Hostess reported Q3’18 adj. EBITDA of $40MM compared to street estimates of $45MM. The main driver of the miss was higher inflation (impacted GMs by 330bps) as well as the Cloverhill acquisition, which as a reminder is negative EBITDA right now (but expected to be $20-$25MM by 2020). The company has announced price increases to cover raw materials, which I think will be easily passed through, as I’ve discuss in my previous posts on pricing power (e.g. moving Twinkies price to $1.80 to $1.88 isn’t a deal killer for a buyer, but that’s a ~4.5% price increase for the company).
Cloverhill accounted for another 630bps of gross margin degradation. All in, gross profit margin, excl. transaction costs, declined form 40.8% of sales to 30.4%. Some of this was expected, but it definitely disappointed. That being said, there’s still a lot to look forward to for investors with a 2 year outlook.
One, the Cloverhill acquisition should no longer be a drag to EBITDA in 2019 and then will be a nice contributor in 2020. They bought the business for $25MM, so this is an extremely attractive purchase price multiple in an industry where things are being sold for 10-12x.
Second, the acquisition provided penetration into both new brands as well as channels the company didn’t have before. This will allow a new platform for the company to leverage the Hostess brand. For example, the company did not have much in the breakfast channel. This can now be a platform for growth.
Lastly, the company is still a FCF machine. Despite buying a business that is obviously a significant drag on EBITDA, the company has generated ~$131MM of FCF in the past 12 months. That’s ~9% of the market cap (using a fully diluted share count, adding 30MM of class B shares, which many sell side analysts don’t use due to focus on EPS).
Outlook: When you look out to 2021 when Cloverhill should be a meaningful contributor and the rest of the business has recovered profitability, I model ~$292MM of EBITDA. As such, the company is currently trading at 6.8x. Using just a 10x multiple, I have a price target of $18/share which foots to a 6% FCF yield. I think this is relative conservative compared to where other food names trade, especially those with such a strong brand power as Hostess. Over time, I think the business should move up to 12x EBITDA, which foots to $22 stock price.
I’ve written about the warrants in the past and these price targets would also foot to a $3.25 and $5.25 price compared to their current levels today at ~$1.00. I am long both today.