Mixed bag expected in 2018
Going into 2018, Farha Aslam, managing director, Stephens, Inc., New York, said a mixed bag is likely once again with a mixture of winners and losers.
“Companies in the right categories will be well positioned,” she said. “Companies that focus on the periphery of the store, particularly on produce and protein and deli will do well. Companies with strong innovation such as Pinnacle and B&G Foods will benefit from the growing interest in frozen. Companies with successful M&A programs, for example, Hormel, will do well.”
High on Aslam’s list of promising companies is Calavo Growers Inc., Santa Paula, California.
“Calavo is an avocado company with a strong presence in guacamole and a growing business in fresh cut fruits and vegetables as well as meal kits,” she said. “It has done well and is very well positioned with its supply chain and distribution capabilities to succeed. We believe it will continue to perform well.”
Protein companies also are likely to do well in 2018, she said.
In grain-based foods, Aslam has a neutral view toward Flowers Foods Inc., Thomasville, Georgia, but is upbeat about Hostess Brands, Inc., Kansas City.
Flowers Foods has eyed and struggled with the periphery of the supermarket with its acquisition of Alpine Valley Bread Co., one of two organic bread baking businesses Flowers acquired in 2015. That the second and larger acquisition, Dave’s Killer Bread, has done well and Alpine has struggled does not surprise Aslam.
“The periphery of the store has its own supply chain, its own buyers,” she said. “It is a different skill set. As they move in, there is a lot of learning to be done.
“Flowers acquired two organic brands — D.K.B. and Alpine. Alpine was purchased partially because they had capacity to produce D.K.B. In that sense, the acquisition has been a success because they got the capacity. Alpine as a brand has struggled because there has been so much growth and focus on D.K.B.
“They want Alpine in their portfolio. They’ve recently hired a new chief marketing officer, and that CMO will look at their whole brand portfolio and really segment where each brand should play. I think that will help Alpine going forward.”
Tempering Aslam’s view of Flowers has been the “lackluster” performance of the company’s core portfolio. She emphasized efforts by Flowers to invigorate the business through the hiring of Debo Mukherjee as CMO and cost reductions necessary to fund increased marketing and innovation.
“Our neutral view reflects our concerns that there may be need to invest in marketing and innovation ahead of the cost savings, which will dampen earnings for fiscal 2018,” she said. “The cost inflation they will face along with the marketing investments we believe are going to be quite significant in the near term. We think Project Centennial is the right long-term direction for the company. Near term, we think earnings are going to be subdued because of the investment.”
Notwithstanding doubts that have been expressed about whether Hostess Brands will sustain its momentum, Aslam remains upbeat about the company’s prospects.
“They articulated a target for this year and are well positioned to hit the target,” she said. “The growth was very first-quarter and fourth-quarter weighted. Mid-year doubts emerged as to whether they could hit their full-year numbers. There is no history of this company in the public markets and the management team. We are very positive on Hostess. They have done a terrific job of growing shelf space with innovation.”
For example, Aslam described the company’s recently introduced Bakery Petites as “on trend.” She noted that the product made its debut at Walmart and is being rolled out more broadly.
“Hostess innovations have a lot of legs,” she said. “Chocolate Twinkies, peanut butter Ho Hos, an expanded breakfast line. They are introducing very high-quality innovation.”
Brett M. Hundley, Vertical Group, Richmond, Virginia, is more upbeat on Flowers’ prospects, despite the company’s challenges. Vertical Group has rated Flowers a buy since initiating coverage in December 2016 (at $15.48 per share).
“We’re very positive on Flowers,” Hundley said. “They are clearly facing ongoing headwinds in the fresh bread category. We also think they’ve been somewhat outmaneuvered on the cake side by Hostess, but we are very encouraged to see them executing on Project Centennial cost savings plan. I think it will put them in a much better competitive position to be able to spend brand support dollars against product innovation and distribution.”
Also a positive at Flowers is the company’s position in the organic marketplace with Dave’s Killer Bread, a brand with further growth potential, Hundley said.
“The last few years have been difficult for Flowers, but we do see a viable pathway toward sales growth generation and improving margins ahead,” he said.
Other grain-based companies viewed favorably by Vertical Group include TreeHouse Foods, Inc., Oak Brook, Illinois, and Lancaster Colony Corp., Westerville, Ohio.
TreeHouse was upgraded to a buy rating in November from a hold.
“TreeHouse has quickly become one of our favorite names,” he said. “We acknowledge the high leverage profile in place. We acknowledge the many missteps by management as it has integrated the Ralcorp asset from Conagra. We think this is a true case of growing pains. This company got too large too quickly. And while it’s found itself in a tough spot as a result, we do think this is a bottom, and we are encouraged by technology that has been put in place recently across the company that will now allow it to analyze profitability by plant, SKU, customer, etc. We do see a pathway out as the company reduces a far-too-complex SKU count while also streamlining operations. With the valuation where it is today relative to the peer set, if they can execute their way out, we see a lot of upside for the shares from current levels.”
The appeal of Lancaster Colony is not its valuation, Hundley said. Instead, Vertical is attracted to its strong positioning in traditional food retail as well as food service. Lancaster manufactures a range of dressings and dips as well as various baked foods and noodles. Hundley described the company as “high quality” and “robustly” valued with a clean balance sheet.
“It’s not sexy,” he said. “They’re not involved in snacking per se. They’re not overly weighted toward organic or natural. But they’re positioned well in growth areas of grocery, along the perimeter in fresh or frozen. Their Flatout flat bread is sold along the perimeter. They sell frozen bread. Outside the grocery store, they’ve enjoyed good growth in food service.”
In the ready-to-eat cereal sector Kevin V. Dreyer, co-chief investment officer, value, Gabelli Funds, New York, favors Post Holdings, Inc., St. Louis. The largest players in the space — Kellogg Co., Battle Creek, Michigan, and General Mills, Inc., Minneapolis — “have had their issues,” he said.
“At General Mills, certainly the yogurt business has been a disappointment for many years,” he said. “The company’s new Oui line by Yoplait seems like a good play, but we will see about execution.
“Kellogg is doing an OK job as they morph toward snacks.
“At Post, they are performing well in cereal. Post has very capable management. I expect them to continue to integrate acquisitions.”
A bit more cautious toward Post is Hundley, rating the company a hold.
While Vertical’s view of Post has been improving, he said caution is justified because of the company’s high level of debt.
“They do run this enterprise like private equity,” he said. “So, the argument can be made they can maintain a higher debt profile relative to peers. It’s something to be wary of in our opinion. We have a high degree of respect for this management team. Because they manage like private, they can engineer value more quickly for shareholders.
“Some of their business areas are of some concern for us. They’ve been able to realize a lot of value in their cereal business from combining Malt-O-Meal with Post, but we’re somewhat wary of the category in general and commentary from Kellogg and General Mills that suggests they will become more engaged with their own businesses.”
Still, he noted that the Post Michael Foods business is rebounding with the potential to drive earnings growth. He said cost synergy savings from more recently acquired businesses/brands (Weetabix and Bob Evans) represents an opportunity.
“There is a fair amount of center-of-store exposure in Post,” Hundley said. “That keeps us somewhat grounded with our forward expectations.”
While recommending a handful of companies, Hundley maintains a fairly sober view of prospects for the packaged foods sector overall and instead sees promise in companies focused on value-added ingredients.
He said, “For food companies to regain revenue growth profiles they want either 1) they will need to become more amenable to a lower margin profile, or 2) they will become even more leaner and take out incrementally more in the way of cost in order to try to maintain margin structure while still generating revenue growth. It’s really a tale of two stories between packaged foods and ingredients. Packaged foods revenues are under pressure. They are fighting like crazy to maintain margins, and their leverage profiles have worsened. A large part of that is expensive deal making. They’re trying to gain greater scale through M&A, and that M&A is proving expensive.
“Ingredient companies are still seeing very good revenue growth. Balance sheets are in great shape. They have to work to maintain the margin structures, but thus far they are in much better shape than their packaged foods customers further downstream. The ingredient space is vast, depending how you define it. We typically look at the specialty ingredients market, which would be ingredients that aren’t as commoditized.”
Hundley said Vertical estimates annual global sales of specialty ingredient total about $75 billion annually.
He noted that companies such as Ingredion Inc., Westchester, Illinois, and Tate & Lyle PLC, London, have taken steps in recent years to tilt their ingredient portfolios more heavily toward specialty ingredients. A major step in that direction for Ingredion was the company’s (formerly known as Corn Products International) $1.3 billion acquisition of National Starch in 2010.
“They have continued to pursue that specialty mix, with the acquisitions of Penford Corp. (in 2014) and Kerr Concentrates (in 2015),” Hundley said. “I think the pursuit has helped their valuation to a degree, but it still lags the peers. We see a group today that trades at almost 25 times forward EPS and almost 16 times forward EBITDA. A really expensive group but warranted in our view because revenues are growing, margins are relatively stable and balance sheets are strong. Plus there is a lot of consolidation potential ahead. It is a fragmented group.”
Ingredion and Tate & Lyle also have benefited from improved market conditions in the companies’ more commoditized ingredient businesses.
“When Cargill closed its Memphis plant, that greatly reduced supply of commoditized sweeteners and starches and swung the pendulum in favor of the US corn wet milling industry,” he said. “It has seen robust margins on more commoditized ingredients in sweeteners and starches.”
At the same time, Hundley expressed concern over the highly fragile state of negotiations over NAFTA. Noting the significant level of US high-fructose corn syrup (HFCS) shipments to Mexico, he warned that an interruption of that trade could have significant effects on the US sweetener supply/demand situation.
He said his concerns were mollified by November presentations by Ingredion executives during an investor day presentation.
“First of all, Ingredion is not as commoditized as we originally thought in the United States,” he said. “Second, there has been talk out of Mexico that if NAFTA does dissolve, that Mexico may not react as strongly on US. HFCS as had once been thought. Mexico not only needs US corn, but also needs US corn sweetener. It also relies heavily on the US for own sugar exports. So, the end result is it doesn’t want to get into a trade spat on cross-border trade related to sweeteners.
“We see very supportive fundamentals for specialty sweeteners and starches going forward. We expect growth at mid-single digit rate or higher going forward. The main support for that is changing formulations with packaged foods and beverages industries. As the companies change formulations away from synthetic ingredients toward natural ingredients, formulations become upended, and stabilizing ingredients are required in order to bring flavor and texture profiles back to the original product state. Specialty sweeteners and starches are prime remedy for the challenges, important for the move toward natural.”
Other companies Vertical rates favorably are Sensient Technology Corp., Milwaukee, and Innophos Holdings, Inc., Cranbury, New Jersey. The attraction of Sensient is the combination of both colors and flavors in its product portfolio, Hundley said. He said valuation make Innophos attractive.
