“I can understand [Coca cola]… Anyone can understand [it]… It’s a simple business.”
Today’s stock pitch is a simple business. It’s easy to understand and in many ways, it is very similar to Warren Buffet’s Coke investment. And that is… Hostess Brands! That’s right – the maker of Twinkies, Ho-Hos and Ding-dongs, is making a pitch appearance.
Food staple stocks have been under pressure recently, relatively speaking. Call it sector rotation or moving out of bond proxy stocks (i.e. those equities viewed as safe enough to move into when interest rates are too low), but the indiscriminate selling as opened up buying opportunities.
So what’s the pitch for Hostess Brands?
- Strong brand name
- Great return metrics (high EBITDA margins, little capex)
- Very stable business (people don’t stop eating Twinkies in a recession)
- The stock may be looked over due to misguided perception of healthy vs. indulgent snacking
- Plenty of white space to drive growth
But DD – aren’t Twinkies bad for you and isn’t that segment shrinking?
Good question Reader, but the answer is yes and no. I will just note that a Twinkie is only 135 calories – that’s less than half the calories of a Twix bar. But, yes the health-conscious segment is growing, but the indulgent snack trend is still strong. In fact, indulgent snacks have posted low single digit growth rates over the past several years, roughly in-line with healthy snacks (3.1% and 3.4% in 2014 & 2015 respectively vs. 2.5% and 3.8% for healthy snacks).
Ok, even if that’s true, didn’t Hostess declare bankruptcy? Yes! But it has emerged as a much stronger company. Hostess’ previous distribution strategy drove it into bankruptcy. Hostess declared Ch. 7 bankruptcy, which means it went into liquidation. After selling some brands (Wonderbread) and shedding liabilities (pension etc.), Apollo bought the Hostess brand name and reinvested in the business, utilizing automation and a direct distribution strategy to drive efficiency. The table below summarizes it well.
It should be noted that since Hostess entered Ch. 7, its products were pulled from the shelves and competitors took market share. Now that Hostess is back, one reason why it is growing well is simply that it is regaining that market share.
Another reason why I like Hostess is simply the amount of white space available to the company. With the acquisition of Superior Cake the company entered a new space of in-bakery items. Hostess has since then launched a series of peanut butter products, deep fried Twinkies, and chocolate covered items. New product introductions like these should drive better than GDP growth over the long-run.
Another way Hostess can drive growth is geographic white space. Its mostly a U.S. company today and I could easily see a launch of Hostess products moving into Mexico and South America, where Grupo Bimbo dominates.
“Coke’s moat is wider than it was thirty years ago. You can’t see the moat day by day, but every time the infrastructure gets built in some country that isn’t yet profitable for Coke, but will be twenty years from now, the moat is widening a little bit… That’s the business that I’m looking for. Now what kind of businesses am I going to find like that… I’m going to find them in simple products. Because I’m not going to be able to figure out what the moat is going to look like for Oracle, or Lotus, or Microsoft ten years from now…”
Financials & Valuation
Aside from good growth, I really like the free cash flow characteristics of Hostess’ business. With 30% EBITDA margins and capex (including growth capex) at around 5% of sales, that means a lot of earnings translate into free cash.
And given these goods cash flow characteristics, strong brand value of Hostess I would put Hostess’ valuation in the top tier of peers. But when we look at where the comps trade, there is clearly a dislocation and opportunity for investors.
I think Hostess should trade at 13x EBITDA, and perhaps higher. As seen at the bottom of my model snapshot, this is pretty close to a 5% FCF yield, which I think is fair. For this point, I’d also like to highight how much cash builds on Hostess’ balance sheet. It is unlikely that they just sit on this cash – this will likely go to acquisitions, share buybacks, or even eventually, a dividend.
This is the time to bring up the fact that the CEO is leaving. He is well respected in the industry and I can’t say this isn’t a loss for the company. I do still like that Dean Metropoulous will remain executive chairman, a leader who has more than 30 years of experience in the food & beverage space.
What do you guys think? Let me know if you guys have any thoughts or questions.