2023-05-14 23:20:40 ET
Summary
- My thesis on Hostess has been relatively unsuccessful. What I mean is that the company has outperformed my "HOLD" rating since 2022.
- A quality company can always surprise you in their ability to weather even the worst storms. Hostess Brands has done just that.
- However, this does not always warrant a thesis change. I remain more unconvinced than before in the company's potential at this price.
- I'll show you why this company remains a "HOLD", but also acknowledge my too-low initial targets.
Dear readers/followers,
Hostess Brands ( TWNK ) is an undoubtedly attractive company - but I've held a "HOLD" rating for the company for almost a year at this time. That being said, the company has actually outperformed this rating a bit. Since my last article with this rating, the company has expanded 11%, with the market up just over 7%, meaning a variance of around 4%. This is above the margin for error and implies outperformance on the part of the business.
In this article, we'll go through what caused this outperformance, and what we can expect from the company as we go forward. To be clear from the get-go, I'm not changing my rating for TWNK stock - I'm confirming it. But I'll explain to you why I am perhaps less positive than the overall street, and why historical trends actually support my stance, which is to "BUY" the company far cheaper than it trades today.
Let's get going.
Hostess Brands - a lot to like here, but at a price premium
Hostess Brands, together with its subsidiaries, is a leading sweet snacks company. It's focused on the research, development, manufacturing, marketing, and distribution of snack products in the North American market. It produces some of the most recognizable snacks on the entire market, including the very traditional and well-known Twinkie - but also CupCakes, Ding Dongs, Zingers, and Voortman-branded cookies, to name but a few.
When we look at the company's comparative fundamentals and profitability, we find a lot to like. The company is above average in almost every single profit indicator, be it gross, operating, or net margin, or some of the RoE/ROA/ROIC metrics. Its ROIC with the weighted average cost of capital netted out, or WACC, is 4-5% over the past few years, which implies a company with extremely good cost control, knowledge, or expertise in knowing where and how to invest its capital. This is admirable, and it is excellent.
The company generates annual revenues of over $1.4B. While its traditional net income generation has been more volatile than you'd expect for this sort of snacks-based business...
Hostess Brands IR (GuruFocus)
...earnings from those revenues over time are still solid. The company is somewhat average in terms of fundamentals - debt is higher than peers at around 36% of debt/cap, and the company is actually only BB-rated, which is one of the primary drawbacks we can identify here.
It's hard to take away that the company is really one of the best-growing snack plays though, and it outperforms most peers.
TWNK IR (TWNK IR)
The company's advantages and arguments for investing hinge on a working business model that results in a net profit above 12%, with very good cost and operating expense control. Remember, COGS is the costs related to sold goods, while OPEX or operating expenses are costs incurred whether the product is sold or not - control of both is very important for a working business.
Hostess has no international diversification. It's a pure-play NA brand, with a 98.5% USA exposure. This is the second disadvantage that I would argue about. In order for me to be able to buy some Twinkies or Ding-Dongs, I have to pretty much import them or go to one of the import stores that sell US products. This lack of internationalization is also a drawback that I consider relevant for most companies I look at.
TWNK reported 1Q23 only a few days ago, so the results are still "warm", so to speak. Any company like this is going to be relatively slow-growing, and TWNK has confirmed this, with net revenue growth of around 4%, though a higher CAGR. Point of sales growth is up about half a percent in Sweet Baked, and 10% in Voortman branded - so that M&A was a good idea given the growth we're seeing.
TWNK IR (TWNK IR)
The sales mix is also important. Much of the recent sales increases come from new products and innovations, which include Hostess® Kazbars™, Old Fashioned Donettes® and Chocolate Baby Bundts, and Voortman® Zero Sugar Mini Wafer.
What I like about a company like TWNK is that the net revenue growth also translates well into the bottom, indicating strong cost control. While plenty of FMCG's are seeing growing costs and as a result, harsh margin pressures, TWNK is keeping those under good control. I recently reviewed a peer who is seeing a significant margin decline - Orkla ( OTCPK:ORKLY ) - but TWNK is only seeing margin declines of 0.04% for the quarter on a YoY adjusted EBITDA margin, and EPS growth of 3.7%.
However, I do want to point out that these increases in both the top and bottom line come woefully short of the forecasts which are used to justify the street recommendations for the valuation of Hostess. Current forecasts land at a 10-15% EPS growth for the year - and while later quarters may deliver more, I take a strong stance against being too exuberant on Hostess or on any company in this environment.
Look at these results.
TWNK IR (TWNK IR)
Yes, the CAGR is good - but I don't see that necessarily translating into massively impressive 2023E results compared to 2022.
Also, the sales and profit increases do not actually mean that TWNK is selling more Twinkies. If we dig down and look at the units, then the organic revenue growth is strictly from price/mix, not volume. Volumes are actually down 10%.
The price mix is driving it up 14%, which comes to that 4% organic net revenue growth. This isn't a bad thing, but it's a thing to be aware of. The company is not selling more - it's selling fewer units, but at a higher per-unit cost.
TWNK IR (TWNK IR)
I don't view this as a risk or as anything worth obsessing over unless it becomes a continuing trend. Even if Hostess has some very strong brands, the snacking category itself is. Snacking is not an inelastic product - Hostess does not sell inelastic products, from a demand perspective. If the price goes up enough, as we're seeing, the volume goes down, and eventually, that will drive into profit.
That is why I am more careful than most investors and analysts following the company. I see these elasticity issues, these volume declines, and these premiums to the valuations which I cannot rightfully justify to myself.
The company can still point to very strong growth trends, and market share growth as well as expansion - but these do not necessarily go deeply into what I am talking about here.
TWNK IR (TWNK IR)
The company also, due to its no-yield, continues to buy back shares as a way of returning capital to shareholders, which further muddles the performance. Overall, I think Hostess had a good quarter - not in any way anything to be concerned about.
it still needs to work down its leverage from 3x though, it needs to keep growing, and it does need to turn around the volume trend here, which is firmly in the negative.
Company guidance is alongside my own assumptions for the company - not the other analysts following Hostess, most of them. The company expects 4-6% revenue growth, though how this is in terms of volume and price/mix is unclear. It does expect a 10-15% EPS growth, so there is reason for analysts expecting a 13-15% here, with a CapEx of $170 including capacity expansion.
The company has one of the better margins in the entire industry and clear targets for growth. In the long term, I put into question how those targets will hold up to the economy.
The company wants to grow EBITDA at 5-7% and EPS at 7-9%. That EPS can only come from either driving price or driving volume. Because it's a US-based business with few international expansion plans (none that I am aware of), there is a market limit and a stop to market share growth. This will eventually necessitate pricing increases, new product segments, or other strategies, which involve risk. And it's always to be put next to the risk of customers deciding that Twinkies are too expensive and buying something else instead.
Elasticity, dear readers - to some extent, that's what we have here.
Let's look at the valuation.
Hostess Valuation - It's expensive, and I'm not interested here
The company is more expensive than at any one point that I've covered it before. I'm not excited to invest in Hostess brands here for a simple reason. The valuation relative to its potential, and the near-term and longer-term risks that I see to the company.
TWNK is currently trading at a premium of almost 26x P/E. This is well above its historical average of 20-22x P/E and in itself poses a problem, especially with a company that's BB-rated and with no dividend. Any upside to a future 22.5x historical P/E ratio based on even a double-digit growth rate of nearly 10% until 2025E, is capped at 4%.
Do you want to invest 4% annually when you can get virtually the same from a risk-free savings account?
TWNK upside (F.A.S.T graphs)
Every simple valuation model shows the company being overvalued here. Most analysts I follow or models I adhere to imply a valuation at a fair level of around $20/share - or below it. My PT in my previous articles was at that $20/share level. This is no coincidence, dear readers. It's a result of people calculating conservative upside, as opposed to exuberance based more on expectation, than on fact/history.
If you believe S&P Global analysts then TWNK is worth closer to $30/share, with 6 out of 10 analysts following the company giving it a "BUY", with a low of $25/share and a high of $32/share. That is never something I would accept, and that is why I say a firm "no" to any such assumption or forecast.
I continue to see risks in the company's forward growth potential as the margins and sales become increasingly dependent on price increases as opposed to volume growth in a market where TWNK already has a leading market share. For that reason, I will continue to reiterate my "HOLD" thesis for Hostess and have no position in the company.
Thesis
- Hostess is one of the greatest snack brand companies out there - with industry-leading margins, a great organization, and good growth prospects. It's not outside the realm of possibility that growth could be even higher than expected.
- However, Hostess also comes at a substantial premium, has no yield whatsoever, faces supply chain, inflation, and energy risks as well as the general movement against sugar snacks, and because of that, I'm a bit hesitant to go in here.
- I'll consider the company a "BUY" at around $20/share when the company's upside is higher than 10% - and even then, I'd be careful.
Remember, I'm all about:
1. Buying undervalued - even if that undervaluation is slight, and not mind-numbingly massive - companies at a discount, allowing them to normalize over time and harvesting capital gains and dividends in the meantime.
2. If the company goes well beyond normalization and goes into overvaluation, I harvest gains and rotate my position into other undervalued stocks, repeating #1.
3. If the company doesn't go into overvaluation, but hovers within a fair value, or goes back down to undervaluation, I buy more as time allows.
4. I reinvest proceeds from dividends, savings from work, or other cash inflows as specified in #1.
Here are my criteria and how the company fulfills them (italicized).
- This company is overall qualitative.
- This company is fundamentally safe/conservative & well-run.
- This company pays a well-covered dividend.
- This company is currently cheap.
- This company has a realistic upside that is high enough, based on earnings growth or multiple expansion/reversion.
It can also be argued that the company, due to its BB- credit rating, isn't qualitative enough. However, in this case, I don't see the credit rating as the major risk, but the valuation. It's a "HOLD" Here.
For further details see:
Hostess Brands: I Remain Skeptical, But Acknowledge The Quality