Poor timing on TWNK… Still see the light at the end of tunnel. Q2’18 Recap

“Better to be lucky than good…” the old adage goes… Well, I wish I had just a smidge of luck with my post and position on Hostess (and its more risky warrants). Hostess reported Q2’18 Adj. EBITDA of $47.6MM, well below my estimate of $56.8MM. Although sales were up 6.2%, partially due to the Chicago bakery they acquired, EBITDA was down from $63MM in the prior year and margins contracted from 31% of sales to 22% of sales in the current period.

Yeesh. What a mess. Run for the hills, right? Well, that is what investors did. The stock was down 17.6% today.

Before you hit sell too, I think it is important to parse out what happened.

First, over half of the margin decline was due to the Chicago bakery. As a reminder, this bakery was essentially shut down after an immigration raid. Although it was negative EBITDA at the time, Hostess looked at the business and its brands and figured there was good value to be had. They bought the business for $25MM and it had $10MM in inventory. After turning the business around, the company expects to generate $20MM-$25MM of EBITDA, which implies a solid purchase price. However, in the short term, the negative EBITDA business being added to a highly profitable Hostess core business would obviously weigh on results.  If you have a long-term view, this is still a solid opportunity.

The next part of the miss was cost inflation. Many, many companies have been calling this inflation out (oil and oil derivatives have essentially doubled) and wage and trucking freights have also been very high. Hostess is a solid brand though and if the average price of a Twinkie goes up from $1.80 to $1.88, with that impact sales? Maybe, but in this example, they would get a 10% unit price increase which falls straight to the bottom line.

Lastly, and the hardest to predict, was a customer that changed its display partnership with Hostess. From the call:

“Q2 was directly impacted by the quickly escalating inflationary costs in the supply chain and a decline in retail inventory and consumer poll due to lower promotional support from one large retail partner, as well as additional allowances with customers to drive growth….”

“We had good line of sight to increase and display support behind Hostess in third and fourth quarter at one of our largest retail partners. The corporate change in display philosophy during Q2 not only impacted Hostess, but also drove share loss for this customer. Consistently, across many examples, when Hostess performs well and is growing through merchandising and innovation, Hostess and our customers consistently grow market share together. This particular retailer has been a great partner to Hostess since the relaunch and my discussions with them had been collaborative and focused on profitably growing the category. We are pleased with the merchandising support we have secured from all of our large customers during the back-to-school period, which should help support the sequential improvement we expect to achieve in the third quarter.”

This retailer is highly likely Wal-Mart and as you can see from the commentary, it seems like they have some line of site in this improving.

Bottom line: Disappointing Q, but I am sticking with the company and the warrants. We have until Dec 9, 2021 which gives us a lot of time for the company to realize value. My price target moves to $17.3, which is based on 12x 2020 EBITDA.

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