Description

HAIN produces and distributes organic and natural foods.  It was last written up on VIC in August 2016 by singletrack as a short, and that idea is recommended reading.  Since then the stock is off another 40% (70% from its high), and certain material facts have changed.  New board & management, a reduction in margins from previously unsustainable levels, and some evidence of progress toward a workable strategy are reasons to initiate a long position from here.

The key problems identified in the 2016 write up:

• HAIN is a roll-up of smaller consumer brands, and does not invest sufficiently in advertising to support growth
• Intensifying competition from large CPG companies and private label are taking share
• These two issues combine to lead to weak growth and/or margin deterioration
• Accounting problems:  material weakness, alleged channel stuffing, quality of earnings problems
• Undisciplined acquisition strategy, under a larger umbrella of generally subpar capital allocation

Growth did indeed stall, and margins have declined.  On the positive side since that time, Engaged Capital ran a successful activist campaign ending in board control, top executive talent was added, remediation of controls weaknesses have progressed, the Protein division was announced for sale, and a comprehensive cost savings plan ("Project Terra") was announced and implemented.

Why is this sufficient for the stock to be a long?

In our view, the company is about five years late in implementing a management change.  Irwin Simon's positive traits include being an iconoclast and trend spotter.  He founded and built a successful company; if you invested in the IPO your money compounded at 20% for twenty years.  The company had a good distribution platform in Whole Foods and a number of organic retailers (with the smaller independents served through UNFI.)  They could buy new, underpenetrated but on-trend brands and put them onto their distribution platform, creating outsized growth.  

Irwin Simon's negative traits are in some ways the flip side of this.  He was reluctant to bring in talent from traditional CPG companies or retail, either as management talent or on the board (how iconoclastic do you need to be to add Ray Kelly to the board of a CPG company?).  He did not have the ability or desire to build a modern IT infrastructure, finance & planning function, or supply chain.    He refused to narrow category focus, acquiring businesses in a very wide range of product categories (from traditional tea/pantry/snacks they branched out into perishables like organic bread, refrigerated products like yogurt and high end pressed juice, and organic poultry products.)  Time caught up with him for several reasons.  After 50+ acquisitions, the business simply became too complex.  At the same time, the competitive environments worsened significantly, and at around the same time the old formula started to age.  An increasing percentage of revenue came from brands that were fully distributed across their traditional relationships, meaning a natural and significant slowing of growth. 

Many have hoped that the solution to these problems would just be a sale of the company.  It appears that Engaged pushed to explore a sale, but the difficulty is the widely dispersed product categories.  Even absent the one-of-these-is-not-like-the-other protein business, the product portfolio doesn't map well with any potential acquirer.  Splitting the company into ~4 parts and selling the pieces was presumably considered, but is pretty complex to make work in reality.

Instead, it appears Engaged is trying to make a go of it.  With the talent they have committed to (and Schiller is clearly their selected guy), I believe a company sale is off the table.  But I expect that the Protein sale will not be the only divestiture, with future sales offset (or more than offset?) with acquisitions to bulk up in key categories.  While new CEO Mark Schiller's first public remarks came after less than a week on the job, it's notable that he framed his attraction to the opportunity around strong positions in snacks, baby food, tea, and potentially personal care and plant based eating.  Notably absent from his remarks are pantry and dairy/yogurt.

Asset sales may be uncertain, but for sure there will be a reallocation of investment dollars.  Schiller's nice analogy from his first call was "how do you take the resources that you have and apply them in the places that will give you the largest return versus peanut buttering it across everything?"  For a company that once justified moving into an unrelated poultry raising business by talking about vertically integrating their chicken noodle soup production, this is refreshing.

Are the right people on the bus?

New CEO Mark Schiller was most recently Chief Commercial Officer at Pinnacle Foods, clearly one of the success stories in CPG over the past decade prior to its acquisition by Conagra this year.  He came to Pinnacle from Quaker and Frito Lay, and began during the early stages of Blackstone ownership through the IPO and sale of the company.  His background is pretty broad, with an emphasis in marketing but even more in general management.  His initial comments laid out a general strategy: segment brands to decide where to ramp up investments (reinvigorating key brands with world class marketing) and where to exit, continue path of reducing complexity, and expand distribution.  These map pretty well with what I would say needs to be done to make HAIN into a longer term force in CPG.

CFO James Langrock has been in place for three years now.  The accounting problems came out under his watch, but clearly their genesis started far earlier (in 2014) and the review was self initiated.  Langrock comes from Monster Worldwide, and the out of industry fit doesn't seem perfect.  But he did have to deal with the fallout of an accounting scandal at Monster, which is positive.  He brought in his former Monster colleague Michael McGuiness as chief accounting officer about six months after he started.  The 2017K laid out three big areas of material weakness: revenue recognition, IT controls, and inventory.  The 2018K shows they successfully remediated the first two, which would presumably be the largest areas and the logical first focus.  A plan is in place to remediate the inventory controls.  Notably, no restatements were needed, and it seems the speculation about channel stuffing was less the issue than that they just never built up the necessary accounting capacity for the size of the company.  They added a new CIO a year ago, who had the same role at White Wave Foods.  A further benefit to their remediation efforts should be realized in the quality and timeliness of financial data to drive decision making.

I expect a reorg of management once Schiller gets his bearings.  HAIN has added more executives than they have subtracted over the past few years, and the current organizational structure is confusing (semi-matrix) and likely too top heavy. Two C-level lawyers may not be necessary.  A North America CEO may be duplicative.  For what it's worth, Pinnacle had a clean management team: CEO, CFO, GC, commercial officer and supply chain, adding one more to oversee the acquired Boulder Brands in 2015.  Given that such is his reference point, I expect Schiller to get closer to this structure.  NA CEO Gary Tickle was tasked with getting the US business in order (and is highly paid to do it), but clearly it's still a problem; while 2 years may not be enough time, they saw production challenges in part due to bad forecasting and they haven't turned growth around.  Tickle's most recent previous position was running Gerber at Nestle which he tried to fix with packaging solutions.  Nestle called out in their Feb 18 call that "Gerber has been a drag clearly…for many years" until starting to turn a corner this year by implementing solutions "beyond packaging".  Seems difficult to avoid conclusion that Gerber had a fixable problem, and Tickle wasn't the guy to get it done.  This part is speculative, but would think that data set is in Schiller's mind.  On the marketing front, they brought in Leah Dunmore from Campbell and Mars to run Pantry marketing; given Schiller's statement of priorities, she may get reassigned. 

At the board level, the majority (6 of 11) come from the Engaged settlement.  The caliber of people has clearly been an upgrade, including senior execs in packaged food and retail as well as PE types with deep experience in CPG.  Simon will not stand for reelection, and Chairman and CEO roles will be separated.  The new Chairman is not identified, though possibly it could be the current Lead Independent Director Andrew Heyer, founder of the PE firm Mistral Equity Partners. 

Performance incentives have improved since HAIN received <50% support for its Say on Pay vote in 2015.  Shareholders pushed for further alignment of pay/performance, a longer term view, and greater weight to financial instead of subjective metrics.  Proposals to address these are now implemented.  Current long term incentives are based on TSR relative to peers, and net growth (4% target in 2018).  Glenn Welling is now on Comp committee, and ongoing rational connection of pay and performance seems highly likely. 

Valuation

One significant difficulty with this investment is that the confidence interval around the margin path in the next few years is unusually wide.  Adjusted EBITDA has come down in the last 3-5 years from ~14% to 10%, vs peers in the upper teens.  The biggest culprit is gross margins, which in the US (~45% of total revenue) have deteriorated by 800 bps.  The main contributors to the gross margin pressure: secular trends from competition, increased commodity costs and freight, and trade investments/promotion.  The increased costs obviously impact all suppliers, and HAIN has a 5% broad based cost increase in place (flowing through over the next 2-3 quarters depending on supplier contracts) which will make up ~200 bps.  SKU rationalization will help some, and the current trade investments (which are leading to distribution gains) are temporary. 

On the SG&A side, and to the earlier short point, advertising has gone up (spending 2.5x the levels of 5 years ago, but still just 1.4% of revenue.)  The advertising spend of competitors is still higher, although there is a range (2.5-4.5%depending on strategy).  One key point: you can drive sales with advertising, or you can drive sales with activities that reduce net revenue instead of being expensed (trade promotion, various types of cooperative advertising, slotting fees, in store displays, coupons, etc.)  HAIN has always leaned heavily on the latter; while that should gradually change over time, they can drive revenue growth without a dramatic step change in advertising.  They are in the midst of a major cost save initiative, Project Terra, which they have pegged at $350mm spread across both COGS and SG&A, including sourcing/procurement/transport logistics, SKU optimization, co-packer and facilities consolidation, and systems for sales, ops, and planning.  This is 14% of revenue, most of which will be invested back into growing the business.

I don't have the ability to map out the clear path for margins, but the identified cost saves can go a long way toward overcoming any lack of marketing spend relative to peers.  Meanwhile, the business has a variety of products that are on trend, as organic products overall are growing ~5%. 

HAIN trades at 1.2x EV/sales, down from 2.0 in July 2016.  Adjusted for the sale of the Protein business ($500mm in sales, reported as discontinued operations) at after tax proceeds of ~$400mm (some media reports rumored higher bids; $400 figures only a slight premium to poultry peer multiples given the all organic focus), EV/Sales is 1.05x.  Peers trade in the 2.1 - 3.0 range (and remember, they are pricing in the pressure of an overall decline in the value of brands).  At the current stock price, aggregate divestitures should be accretive.    So the simple way to do this is, assuming they rationalize and get efficient over the next few years, stock could at least double.

At the end of the day, long HAIN means you're making a bet that Engage and Schiller are the right transition from Irwin Simon.  You have to believe they will be more effective than HAIN has been in the past on efficiency and capital allocation decisions.  If those things are true, even though the exact path isn't clear, a large number of the potential outcomes involve making money.

Catalyst

Announced transactions showing greater category focus; margin progression over the next 4-6 quarters