Q3’18 Recap: Slightly disappointing print, but 2 year outlook remains solid. $TWNK $TWNKW

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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.

Hostess Model

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

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“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.

Q4 Earnings Recap: TWNK

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Now that Q4 earnings season is approaching its end and Q1 will begin ramping up before we know it, I wanted to provide a recap of earnings of stocks I’ve favorably mentioned here.

Hostess reported Q4 EBITDA of $58MM, in-line with street expectations. However, sentiment on the stock was very low and ~15% of the float was sold short which resulted in a significant pop in the stock. EBITDA guidance came in slightly light of expectations, at $225MM at mid-point, but part of the reason is due to a bolt-on acquisition which bring in Big Texas and Cloverhill brands to the current portfolio. The business will be initially dilutive by ~$20MM as the former parent was having operational and recall issues. It used to do sales of $175MM and $25MM of EBITDA. Hostess expects it to contribute $65MM while they turn it around and generate at least $20MM of EBITDA by 2020. Since they only paid $25MM for this assets  and since it provides them greater access to the vending, cash & carry and independent convenience stores channels, it seems like a solid strategic buy in an expensive market.

Bottom line: The core business is doing fine, Hostess continues to generate significant FCF, and it’s allocating capital in a smart way. I still think the stock is worth >$20, which is at least 40% upside to today’s levels.

Also note, based on my estimates, by year-end 2019 the company will have >$300MM of cash on the balance sheet. It won’t just sit on that cash, it will either do more acquisitions, buy back stock, or maybe further in the future, initiate a dividend.

Hostess Model Snapshot