AMZN - Simply Good Foods: Fundamentals Should Bottom Soon

2023-06-21 10:01:16 ET

Summary

• Simply Good Foods Company is expected to see revenue growth from Q4 FY23 due to easier comparisons and strong end-market demand trends.
• Margins are anticipated to improve as supply chain efficiencies are gained and ingredient costs moderate in the upcoming fiscal period.
• With a discounted valuation compared to historical levels and positive long-term growth prospects, SMPL stock looks like a good buy.

Investment Thesis

The Simply Good Foods Company ( SMPL ) has faced challenges during the first half of fiscal 2023, primarily due to tougher year-over-year comparisons and a difficult cost environment. However, the company's medium to long-term growth prospects remain promising.

Looking ahead, revenue is expected to benefit from several factors. These include easier comparisons, improved alignment of sell-in with end market point-of-sale ((POS)) growth, the secular trend of increasing demand for a healthy lifestyle, and the recovery of buy rates at the Atkins Brand. Furthermore, the implementation of enhanced marketing initiatives and increased brand awareness should contribute to long-term revenue growth.

Regarding margins, the company is poised to benefit from improving supply chain efficiencies and moderation in ingredient costs in the upcoming fiscal period. Moreover, I anticipate that the third quarter of FY23 should represent the bottom of the challenging operating environment, with sequential revenue and margin recovery expected from the fourth quarter of FY23 onwards.

Considering the stock's current valuation, which is discounted compared to its historical levels, along with the positive long-term growth prospects, I have a buy rating in SMPL stock.

Revenue Analysis And Outlook

In my previous article published in March, I discussed the medium to long-term sales growth prospects for SMPL, highlighting the company's position to benefit from the secular demand trends towards a healthy lifestyle and positive point-of-sale growth at e-commerce and mass retail channels.

Since then the company has reported its Q2 2023 results and during the quarter, the company witnessed robust point-of-sale growth of 16% across both measured and unmeasured channels, indicating strong demand for nutritional snacking categories in the end market. Additionally, price increases implemented by the company contributed to sales growth. However, as mentioned in my previous article, the unusual retail inventory buildup during the first half of 2022, has resulted in challenging YoY comparisons, impacting the company’s revenue growth. Consequently, the company reported flat year-over-year revenue growth, amounting to $297 million, consistent with the previous fiscal year’s second quarter. This flat growth reflects an 8.2 percentage point benefit from price increases, which was offset by a 6.9 percentage point decline in volume and a 1.3 percentage point headwind from the divestiture of Quest's Pizza business.

Looking ahead, while Q3 FY23 should also be impacted by tough comparisons, I anticipate that SMPL will be able to achieve revenue growth starting from Q4 FY23 and throughout the next fiscal year as the comparisons normalize and the company benefits from the strong underlying end-market demand trends.

SMPL's revenue growth has been affected by the unusual inventory adjustment patterns resulting from comparisons with retail inventory adjustments in fiscal 2022. At the beginning of 2022, retailers stockpiled excess inventory in anticipation of growing consumer demand as pandemic-related restrictions eased and pent-up demand surged. However, the excess inventory buildup in the first half of 2022 led to inventory readjustments and destocking as demand began to normalize in Q4 last year. This created a unique inventory adjustment pattern for retailers, impacting SMPL's sell-in during the first half of 2023 and affecting year-over-year comparisons. Management expects Q3 FY23, ending in May 2023, to be similarly impacted by excess inventory. Consequently, I anticipate that point-of-sale figures should again exceed reported sales growth in Q3. However, as SMPL moves into Q4 FY23 and the subsequent fiscal year, the easier comparisons resulting from an inventory destocking in the latter half of the calendar year 2022 will become a tailwind for revenue growth.

In the medium term, the sell-through rate should eventually align with the strong end-market demand for the nutritional snacking category and the company should post good growth. The underlying demand for nutritional snacking remains robust, as demonstrated by the healthy POS growth observed at Quest, which constitutes approximately 54% of SMPL's total sales in North America.

The Quest Brand, offering protein bars, shakes, chips, and cookies, continues to be a popular choice for consumers seeking healthy snacking options. The demand for Quest's products remains strong, and the company's efforts to shift its consumer base from programmatic dieters to lifestyle consumers have been successful in driving increased demand. The introduction of new, tasty low-carb, low-sugar, and high-protein snacks has further contributed to this growth. As SMPL continues to innovate and provide nutritional and delicious options to meet consumer snacking needs, I expect the strong end-market demand to support sales growth in the coming years.

Furthermore, SMPL is poised to benefit from an improved portfolio mix for the Atkins brand and increasing sales through e-commerce channels. SMPL is focused on improving the product size mix (multipack vs smaller packs) of the Atkins portfolio through rightsizing across all snacking categories. This, combined with the secular demand for healthy lifestyles, is expected to increase Atkins's buy rates and support overall sales growth. Additionally, the company has experienced significant growth in e-commerce sales for Atkins, with a 35% year-over-year increase in point-of-sale at Amazon ( AMZN ) in Q2 FY23. This growth can be attributed to the shift in consumer behavior towards e-commerce platforms and the company's digital marketing initiatives. Therefore, the recovery of the Atkins brand and the growth in e-commerce sales are expected to contribute to sales growth in the coming years.

Moreover, SMPL is focusing on improving its marketing and advertising initiatives for both the Quest and Atkins brands to enhance brand awareness and increase household penetration. The upcoming appointment of CEO Geoff Tanner, known for his successful track record in leading marketing and sales divisions for major food companies like J.M. Smucker ( SJM ), Del Monte Foods, and Big Hearts Pet Brands, is expected to bring new growth opportunities. His experience in leading Smucker's successful turnaround plan and driving organic sales growth and margin expansion should be beneficial for SMPL and the arrival of Tanner as CEO is likely to result in the growth of the consumer base, distribution, and market share for SMPL, supporting the company's long-term sales growth.

I believe that the third quarter should mark the bottom of the volume decline and post-Q3, the company should be able to return to delivering strong sales growth from Q4 onwards.

Margin Analysis And Outlook

In the second quarter of 2023, SMPL faced challenges with higher commodity and packaging costs, which had a negative impact on the company's margins. Additionally, unexpected increases in other costs within the supply chain further weighed on margin growth. Furthermore, the moderation of ingredient costs and drawing down high-cost inventory has been slower than anticipated, prolonging the impact on margins. As a result, the gross margin declined by 200 basis points year-over-year to 34.6%, while the adjusted EBITDA margin decreased by 110 basis points year-over-year to 17.2%.

Looking forward, Q3 FY23 is expected to continue to be negatively impacted by incremental costs associated with the supply chain. SMPL focused on improving its fill rate and increasing capacity last year in response to higher-than-normal retail inventory built in 1H22. As inventory patterns normalize, the company is working on improving supply chain efficiency to match lower production rates and adjust finished goods inventory levels. This has resulted in additional charges related to production runs, purchases, and the overall operating environment, with the highest charges expected in Q3 FY23. Management anticipates a 100 basis points year-over-year decline in gross margin for Q3 FY23 due to this unexpected headwind.

However, I believe that as we move into Q4 of the current fiscal year and into the fiscal year 2024, margins should expand. The company is currently experiencing slower production runs as it right-sizes its inventory levels in response to normalized customer orders. This has resulted in a slower flow-out of high-cost inventory and a slower materialization of moderating ingredient costs, particularly lower dairy protein costs, through the profit and loss statement. As the company's sell-through better aligns with retail inventory levels and production rates normalize, the moderation of inflationary costs flowing through the profit and loss statement should contribute to margin expansion. Additionally, gains from supply chain efficiencies are expected to support margin improvement in the coming fiscal year. I anticipate sequential margin improvement in Q4 FY23 and overall margin expansion in FY2024.

The supply chain expenses and margin growth uncertainties caused by them are temporary in nature, and I am not concerned about the margin growth prospects ahead. Once the company moves past these transitory costs associated with working capital, it should resume its margin growth. Overall, I remain optimistic about the medium to longer-term growth prospects for SMPL.

Valuation and Conclusion

The Simply Good Food Company is currently trading at a price-to-earnings (P/E) ratio of 23.19x based on the FY23 consensus earnings per share ((EPS)) estimate of $1.58, and a P/E ratio of 20.63x based on the FY24 consensus EPS estimate of $1.78. These valuations are significantly below its historical 5-year average forward P/E ratio of 28.77x. While FY23 has faced some setbacks due to unusual year-over-year comparisons and a tougher cost environment, the growth prospects in the coming years are encouraging. The company is expected to benefit from secular demand trends towards nutritional snacking, the improved marketing and advertising approach under the new CEO, and an overall favorable cost environment. Considering the medium to long-term growth prospects and the lower valuation compared to historical levels, I maintain my buy rating on the stock.

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