Hostess' Brand Strength Offsets Health Trend
We think the snack maker is well suited to cater to consumers' continued desire to indulge.
Hostess Brands’ (TWNK) brand strength and prospects for continued return generation despite challenging category dynamics are often misunderstood, in our opinion.
While we expect the U.S. health food trend to persist and strain the sweet baked goods segment, we argue that Hostess is better suited than its peers to navigate this, thanks to its premium brands with demonstrated pricing power monetized through a low-cost, flexible production and distribution infrastructure. Memories are fresh of Hostess’ recent woes, which culminated in liquidation in 2012, but we believe resurgence under a strong management team has left the company with financial flexibility and the resources to invest in innovation and its brands.
We believe legacy Hostess’ brand strength was obscured by suffocating labor agreements, direct-store delivery costs, and an expensive production network, which restricted investment in innovation to combat category dynamics and combined with leverage to force bankruptcy. With its products consistently priced at a premium and market share rebuilding quickly, we think the narrow-moat company is poised for further return generation after emerging from bankruptcy with strong brands and a lean manufacturing and selling operation.
However, with Hostess shares rebounding from their November lows, we would look instead to wide-moat Mondelez (MDLZ) to capitalize on the demand for snacks, as the larger, diversified snacking leader trades at a 13% discount to our fair value estimate.
Sweet Snacks Still Have a Place in the American Diet
The American plate is changing, with consumers increasingly favoring foods they perceive as healthier, including high-protein, low-carbohydrate, simple-ingredient, fresh, and natural fare. In a 2015 Packaged Facts survey, more than half of the adults contacted indicated that they try to eat healthy foods, which has led to category-beating growth for products marketed as natural, organic, or free of genetically modified organisms. Still, consumers are often flummoxed by inconsistently defined terms and opaque nutritional evidence, and while the U.S. Food and Drug Administration sought in 2016 to define the meaning of “healthy” when used on product labels, a 2017 International Food Information Council Foundation survey indicated that 78% of respondents reported encountering conflicting information on what constitutes such an item. The confusion has led the majority of such conflicted shoppers to doubt the health choices they make, according to the IFIC report.
The result has been a dramatic uptick in the availability of health-oriented foods that claim one or more benefits, a shift that has led several food manufacturers to adjust their recipes in an attempt to cater to consumer demand that changes with health fads. We believe scaled packaged food companies’ sluggish response, coupled with mixed results with reformulations and ongoing consumer distrust of large food manufacturers (along with the relative ease and low cost of reaching new shoppers online), has opened the door for small upstarts to enter.
Manufacturers are increasingly forced to strike a delicate balance with their legacy labels. While consumers are broadly seeking healthier items, taste reigns supreme, and deviations from tenured, traditional items’ flavors or appearance in service of health benefits are often met with shopper disdain, as experienced by General Mills (GIS) after it removed artificial colors and flavors from Trix cereal in 2015 and by Unilever (UL) after its maligned 2015 reformulation of its butterlike spreads, which was meant to favor simpler ingredients. In the Packaged Facts survey, 60% of respondents said they eat foods that they like regardless of calories, and 84% of respondents in the IFIC survey said taste was a top driver of their food-purchasing behavior compared with the slightly more than 60% that cited healthfulness. We believe this puts a premium on legacy manufacturers’ efforts to innovate via line extensions and new on-trend lineups, as well as their ability to acquire and integrate small companies that feature products consistent with emerging customer demand, balancing their slow-growing but still solidly profitable workhorses. Financial flexibility is critical to achieving this level of agility and is a key factor differentiating legacy Hostess from its current, nimbler incarnation.
The health trend has coincided with American consumers’ increased desire for portable snacks--the core of Hostess’ offerings--at the expense of traditional large-format family meals at the table. Snack consumption is increasing, providing a rare growth area in the otherwise sluggish center aisles of the grocery store. We expect this trend to continue as shoppers look for culinary experiences consistent with a fast-paced lifestyle, and we suspect that younger millennials and Generation Z will continue this trend as their increasingly snack-heavy childhood experiences influence their future buying behavior. Fully 50% of all eating occasions are snacks, according to industry group IRI in 2016, with nearly half of adults snacking three or more times a day (up from 30% in 2011, with a 5-point uptick in the last year alone).
Consumers have been receptive to premium snacks, with the high-end segment leading overall category growth. We believe this reflects consumer willingness to spend for a product with better taste or more of the attributes they desire and is an advantage for premium-positioned brands like Hostess at the expense of private-label and value offerings. Additionally, even premium snacks are often more affordable than larger meal items, making a high-end experience more accessible.
Highlighting the tension between customers’ intent to eat healthier foods and their buying behavior, 2017 IRI data indicates that the core indulgent snacks segment outgrew its health-oriented counterpart for the year (3.4% dollar sales growth versus 0.9%), with 91% of consumers indicating that they choose snacks based on taste. Sweets account for 48% of all snacks, followed by savory items at 31%.
The shift toward health-oriented foods has not ended Americans’ desire to indulge, but we believe it has led to format changes, supported by snack food manufacturers’ statements that smaller packages and single-serve offerings are growth drivers. We think that this is attributable to consumers’ desire to achieve healthier outcomes via portion control while continuing to enjoy indulgent fare, and that the shift has been constructive for manufacturers because the smaller formats carry higher unit margins. The format shift comes as the segment adjusts to an increasingly important emerging digital channel, growing in the midteens versus low-single-digit expansion for other formats.
Hostess’ core sweet baked goods category, which collectively accounts for about $6.6 billion of retail sales, sits at a point of conflict between the health and snacking macrotrends, with its products generally far from consumer desires for better-for-you fare but easily adapted to small-portion formats that allow buyers a portable, convenient snack. Adjusted for Hostess’ emergence from bankruptcy, category growth has been virtually nonexistent in aggregate, though full-fat items have rebounded against their fat-free counterparts, a reflection of changing views on the nutritional impact of whole-fat foods. Pastries and doughnuts have been among the best-performing segments in snacking overall, according to IRI.
We project low-single-digit subinflation growth for the sweet baked goods category, as innovation will probably be insufficient to overcome the health headwind. While we believe the shift in consumer preferences should benefit snacking companies like Snyder’s-Lance (LNCE) (set to be acquired by Campbell Soup (CPB)), which derives about a third of its sales from better-for-you products compared with about 25% for the overall salty snack category, we think premium sweet baked goods makers, such as Hostess, should be able to achieve above-category growth as they capitalize on their brand strength. While we believe off-trend legacy brands, including Hostess, have seen their equity diminish in the challenged competitive environment, the packaged sweet baked goods segment benefits from limited private-label penetration, demonstrated by McKee Foods’ Little Debbie unit’s standing as the sales leader despite its position as the value brand. Nielsen data indicates that private label’s share of the sweet baked goods category was only 4% at the end of 2016 versus about 18% for packaged food overall. The top three brands accounted for nearly 60% of 2016 sales. We believe this reflects consumers’ willingness to pay for a premium indulgent product perceived to have a superior taste, such as Hostess’ items, as well as the relatively modest per-pound selling price in the category ($3.64 at the end of 2016).
Slowing Category Trends Should Not Impede Hostess’ Growth
Hostess’ revamped cost structure and more focused product assortment have led to high 20s adjusted EBITDA margins. We expect the company to continue to reinvest cash flow in organic and inorganic growth. With free cash flow to equity of around 16% of sales projected, on average, over the next 10 years, we think Hostess should have several options to pursue accretive growth.
In terms of organic growth, we applaud management’s plans to invest in product development and innovation, leveraging existing products’ brand strength to target new adjacencies. Hostess’ premium pricing makes it a valued partner for retailers, since its lineup carries a higher seller profit margin, and the company has the resources to expand the category through advertising and promotional activities, easing the battle for shelf space for new innovations (Hostess does not pay slotting fees). Close-in innovations, such as chocolate-flavored Twinkies and peanut-butter-flavored items, have only recently been introduced, as the company is finally free to develop and support such extensions without accommodating the legacy entity’s uncompetitive cost structure, and we anticipate Hostess’ commitment to such new items will remain strong.
The fall 2017 launch of Hostess’ Bakery Petites line reinforces our view that the company can leverage its brand equity to further premiumize the category. While we do not believe Hostess’ labels are easily extended to many health-oriented product segments (such as organic or no sugar added), the new lineup shows that Hostess can cater to certain consumer trends. The line features no artificial flavors or colors, does not use high-fructose corn syrup, and uses real chocolate, the four product claims ranked highest by consumers in 2016 Euromonitor and Nielsen data. The packaging, a zipper pack to be sold on grocery store shelves alongside other snack items, mirrors the highly successful introduction of unwrapped bite-size and minicandy in similar stand-up pouches. The bite-size chocolate category saw an 80% dollar sales increase in the first three years after such items were introduced, with 74% of buyers either new or lapsed consumers, culminating in 4.3% growth despite confectionary category declines. We believe this indicates the potential for the new lineup to bring new premium sales without necessarily cannibalizing existing products, particularly as the cake bites and cookie crisps that Hostess has introduced do not have perfect analogs in its traditional lineup.
Premiumization is beneficial from a margin standpoint, but it also fortifies the company’s retailer relationships. Retailer profit margins for Bakery Petites are materially higher than the category average, and we believe this constitutes a portion of Hostess’ intangible-asset-based narrow moat because upstarts without the company’s brand strength (and associated pricing power) cannot command sellers’ attention as easily.
Additionally, we expect a new cookie lineup is forthcoming, tapping an $800 million subcategory in sweet baked goods in which Hostess has not historically had a presence. Management has often highlighted the sector as the one major part of the category in which Hostess does not participate; we believe the company’s introduction of branded in-store bakery items (such as store bakery cookies with Hostess product flavors and nods to traditional products’ appearance) is a preview of what the company can do to leverage its existing brands’ strength. Hostess’ pies, brownies, muffins, and breakfast pastries units each enjoy roughly 10% market share, which we believe the company could eventually achieve in the untapped segment. About $80 million of incremental sales would correspond to slightly more than 10% of fiscal 2016 revenue and could add a little more than $1 per share to our valuation (high-single-digit percentage impact).
In the in-store bakery aisle, we expect Hostess to continue bringing out new products based on its conventional lineup in an attempt to add value to a category dominated by private-label offerings, which account for about 70% of overall sales. While we believe the private-label tradition limits the extent to which Hostess can improve its margins in the segment, we still see an opportunity for the company to bolster and diversify its retailer relationships, particularly because sellers often desire an element of customization. Furthermore, we believe the frozen foods capabilities the company acquired when it purchased Superior can be used to support further product development throughout the grocery store (in-store bakery items are generally delivered frozen).
We are supportive of management’s efforts to derisk expansion into new categories through partnerships and licensing arrangements rather than building the capabilities internally. For example, the company licenses its brands to Nestle (NSRGY) for the production of Hostess-branded ice creams, delivering the snack cakes to the packaged-food giant for incorporation into the frozen desserts. Also, Hostess introduced its Deep-Fried Twinkie in food-service venues in partnership with McCain Foods, which deep-fries and then freezes conventional Twinkies that Hostess provides. Particularly for a relatively small company, we think the risk reduction that such arrangements provide is worth the profitability impact of ceding a portion of the value chain, all while leveraging Hostess’ brand strength in production relationships that put the company in the driver’s seat due to limited switching costs and the relative value provided by the company’s labels compared with further production.
Outside of internally derived expansion opportunities, we anticipate that the company will attempt to use its distribution relationships as a platform for growth via bolt-on and more-transformative acquisitions. In addition to cookies (if Hostess does not pursue the category internally), we would not be surprised to see the company make acquisitions in more on-trend categories, potentially expanding beyond the sweet baked goods category. The company’s whole-grain minimuffins have opened the door to distribution via school lunch programs, an avenue that could be explored further with acquisitions of healthier snack brands. We are encouraged by management’s comments that purchases would have to leverage the existing warehouse distribution model (particularly as we believe distribution scale would be a prime way Hostess could deliver value and achieve synergies from a deal outside its sweet snacks wheelhouse), and we do not anticipate the company would consider a shift into categories that require a direct-store delivery approach. We similarly do not expect the company to deviate from the snacking segment.
Hostess ended fiscal 2016 with net debt at about 4.5 times adjusted EBITDA, and we expect a sub-4 mark in fiscal 2017. Our model assumes the company’s net leverage remains at around 4.5 times adjusted EBITDA long term, and while we model share repurchases as a proxy, we anticipate excess funds will be directed to acquisitions. While leverage is not low, we anticipate the company’s newfound financial flexibility will be sufficient to support the capital structure, with adjusted EBITDA covering interest expense an average of 4 times over 2014-16, which we expect to rise to 5-6 times over the next 10 years.
In addition to being a purchaser, Hostess could find itself the target of a larger packaged goods manufacturer looking to add valued brands with an optimal production and distribution infrastructure. During the 2004-09 bankruptcy, Interstate fended off a bid from Grupo Bimbo (BMBOY), and we believe either it or another packaged food manufacturer could once again make an offer, particularly as Hostess emerged from bankruptcy with only its most attractive brands and a favorable cost structure. In 2015, when Hostess was evaluating options before the Gores Group acquisition the following year, Grupo Bimbo, Flowers Foods (FLO), Post (POST), and Aryzta (ARZTY) were rumored as interested potential bidders in a roughly $2 billion transaction (approximately 10 times adjusted EBITDA).
Should an acquisition occur in the present environment, we would expect Hostess to garner a multiple similar to Kraft’s (KHC) 2010 takeover of Cadbury, at 13 times adjusted EBITDA. Because of Hostess’ brand strength, this is somewhat higher than the 10 times adjusted EBITDA that Grupo Bimbo paid for East Balt (a maker of buns, bagels, breads, and other specialty bakery products for food-service customers) in 2017. Such a level would be fairly consistent with the roughly 4 times revenue Hershey (HSY) paid for snack chocolate maker BarkThins in 2016. A 12-13 times adjusted EBITDA takeout multiple would correspond to a takeout price in the high teens to low $20s.
An acquisition could serve as the fastest avenue for investors Dean Metropoulos and Gores Group to wind down their remaining stakes. Through a combination of Class A shares, Class B securities, and warrants, Metropoulos, who is also Hostess’ chairman, retained a 25% stake in the company as of mid-2017, with Gores holding around 15% ownership. We do not believe that Metropoulos’ stake in the company is permanent, given his history of buying, resuscitating, and then selling portfolio companies, and concede that the overhang could contribute to the shares’ modest discount to our valuation. Still, we anticipate he is not actively seeking an exit yet, as Hostess indicated he will be taking an increased role at the company with CEO Bill Toler’s departure. Management has said it views Hostess as a platform for future growth through acquisitions, a process we expect Metropoulos to start before exiting.
Hostess Rally Makes Mondelez a Better Choice
With Hostess shares up more than 20% after their Nov. 7 nadir--the culmination of a slide that was accelerated by Toler’s retirement announcement in October--we no longer believe the shares offer a sufficient margin of safety against our $15 fair value estimate. Elsewhere in our snacking coverage, the same sentiment holds for wide-moat Hershey, while no-moat Snyder’s-Lance is trading around our valuation ahead of its proposed acquisition by Campbell. We recommend investors looking to capitalize on the snacking trend consider wide-moat Mondelez instead, with an opportunity to capitalize on agita surrounding C-suite turnover in a business with durable long-term competitive advantages.
We believe Hostess has ample runway for continued returns through its premium lineup despite ongoing category headwinds. We don’t think we’re overly optimistic in our top-line forecast over the long term; despite premiumization and performance that should exceed the category’s growth rate, we anticipate Hostess’ long-term revenue growth to average less than 3% after distribution fully recovers and adjacent innovation materializes, below our estimate of long-term food inflation. The top-line limitations should keep adjusted operating margins from reaching the 27% mark seen in 2015 and the 25% result in 2016, although the shift toward more premium items through innovation should keep the profitability metric in the low 20s, still above or on par with the midteens to low 20s of other leading packaged food operators).
In addition to potential overhang from the CEO search and Metropoulos’ potential exit, we believe market sentiment often fails to credit the strength of Hostess’ brands due to the difficulties in the overall sweet baked goods category. We contend that this is a mistake, as the company’s demonstrated pricing power and nimble production architecture make it better suited to navigate the turbulent waters than its peers. As the distribution rebuild and close-in innovation begins to bear fruit, we anticipate that Hostess will boost advertising and promotional spending to around 6%-7% of sales from about 5% in 2015-17. Around 5% of our valuation (roughly $0.70 per share) is attributable to our narrow moat assessment.
Zain Akbari does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.