Description

History

After first filing for bankruptcy in 2004, Hostess found itself struggling again only a few years later. Ultimately the company as it existed at the time could never be healthy due to an unrealistic cost structure which led to a second bankruptcy in 2012, this time a Chapter 7 liquidation. At the time of the second bankruptcy, Hostess had 36 bakeries, 565 distribution centers and nearly 19,000 employees. With a legacy dating back 80 years, the bankruptcy was hailed as the end of an American icon. Consumers snapped up Twinkies by the case and boxes were auctioned off on EBAY for exorbitant prices. Shortly after the bankruptcy, store shelves were emptied and the company’s market share fell to 0%.

Other than its debt load, the primary issue facing Hostess was its unionized workforce and onerous collective bargaining agreements (CBA). According to the bankruptcy documents, the company was party to 372 different CBAs which mandated the maintenance of over 80 different health and welfare benefit plans. In addition, these agreements mandated arcane work rules which hamstrung operations and made them extremely difficult to administer.

All the various rules and CBAs governing Hostess’ employee relations were a legacy of the multiple acquisitions made over many years. These acquisitions increased the company’s geographic reach, brands, employees and overall size, yet these acquisitions came without adequate consolidation and streamlining of infrastructure, employees, and operational processes. Due to excessive costs the company was unable to adequately invest in the business and modernize its manufacturing processes. The company had an extremely inefficient cost and operational structure which made its demise inevitable.

Emerging from Bankruptcy

Hostess was finally forced into bankruptcy in 2012 when its baker’s union initiated a nationwide strike after refusing to submit to further wage and benefit cuts. The bankruptcy separated the liabilities of legacy Hostess such as the pension costs, debt, and union contracts so that the individual assets could be purchased completely unencumbered. However, somewhat surprisingly there weren’t many bids for the snack cake brands, and a joint bid from private equity firms Apollo Global and C. Dean Metropoulos & Co was the highest. In spite of strong brand recognition, many bidders were likely turned off by the uncertainty of the situation and Hostess’ competitors likely wished the brand would die a permanent death. For example, the products had been off shelves for six months, there was no distribution infrastructure, no working capital, no corporate infrastructure and no workforce. Whoever purchased the assets would have to rebuild the company from the ground up. The primary assets were the brands themselves, recipes, and bakeries. Willing to take the risk, Apollo and Metropoulos submitted a bid for $410 million with plans to invest an additional $250 million in the company. Their plan was ambitious and called for producing the same output ($1 billion in annual revenue) with 1,000 employees and five bakeries compared to 9,000 employees and 14 bakeries (i.e. those dedicated to the snack cake business) before the bankruptcy. To do this, Apollo and Metropoulos made several important strategic decisions:

·         Invested $110 million to modernize three factories (even though they bought five, they sold one and closed another after realizing they didn’t need it) including installing automated baking and packaging equipment. This automated baking and packaging significantly reduced the amount of labor necessary to produce the same amount of product.

·         Spent $25 million on an SAP ERP system to manage inventory and logistics. This would be necessary to facilitate the change in distribution post-bankruptcy.

·         The biggest challenge pertained to product distribution. Prior to the bankruptcy, Hostess operated over 5,000 distinct delivery routes which delivered goods direct to stores. Other than excessive costs, another problem with this system is that it limited the reach of the product by excluding certain locations such as convenience stores, dollar stores and pharmacies too small to warrant a trip or that were served by independent distributors. The obvious solution to this problem was to move to a centralized warehouse model where the products would be shipped via common carriers direct to customer or distributor warehouses. However, the challenge was that the 25- day shelf life of Twinkies was not long enough considering the time spend in transit. To solve this dilemma, the company spent millions of dollars working with a food ingredient company to develop a natural enzyme which helped to control the moisture content of flour to prevent mold from forming. This adjustment extended the shelf life of a Twinkie to 65 days and allowed the switch to a warehouse model of distribution. This one change had a profound impact by reducing distribution costs by more than 50% (relative to old Hostess) and also extending the reach of the product into dollar, convenience, vending machines, and drug stores, among others. Hostess began selling bread products including sliced bread and hamburger and hotdog buns as they were able to apply the same technology to extend the shelf life of bread.

Within four months of Apollo and Metropoulos purchasing the brands, products were back on store shelves. For 2014, the first full year under new ownership, Hostess’ net revenue was approximately $555 million with EBITDA of $145 million. 2014 EBITDA wasn’t projected to exceed $100 million at the time of the acquisition. The incredible turnaround in Hostess owes much to the smart strategic decisions made by its new owners but it also speaks to the strength of the brand. Products are discontinued and removed from grocery store shelves all the time but it is quite remarkable that a product could be absent from stores for over eight months and drop to 0% market share and yet make such a dramatic comeback in a relatively short period of time.

Competitive Strengths

Given the long history of the brand as well as the current positioning of the business, Hostess has a number of competitive strengths including:

·         Given the long history of the brands, Hostess is synonymous with snacking in the US. Brand awareness is very high at over 90% and it was likely boosted by news coverage around the bankruptcy and the subsequent comeback. Hostess’ brands have appeared in movies, TV shows and other pop culture venues

·         Given Hostess’ market share and brand awareness, especially in donuts and snack cakes, it has a relatively strong position with retailers which gives it the opportunity to launch new products. From the perspective of retailers, Hostess’ products allow for attractive margins.

·         By investing in its bakeries and establishing the warehouse distribution method, Hostess has realized significant savings in labor and energy costs as well as well as made the business much more efficient. Under the previous distribution method, various products had to be manufactured on multiple lines at multiple bakeries in order to facilitate nationwide distribution. However, now Hostess can manufacture one product on one line in one bakery while having the ability to distribute that product across the nation. This has led to major efficiencies including making it easier to launch new products and/or varieties of existing products. Also, Hostess has the ability to ship products using prebuilt, shippable display cases via warehouse distribution which facilitates the execution of nationwide marketing campaigns with retail-ready displays placed in stores on the same day.

·         Given the investments in automated baking and packaging equipment, Hostess expects to be able to meet future demand with limited additional capital investments. The high level of automation and direct to warehouse distribution system give the company significant manufacturing flexibility.

·         The warehouse distribution method gives the company the capacity to extend its reach far beyond that of legacy Hostess. Hostess now has full access to drug, dollar, and convenience stores which couldn’t be reached via direct delivery.

·         Likely the greatest competitive advantage for Hostess is that it had the lowest costs of all its SGB competitors. Given the fact that all the legacy liabilities went away in the Chapter 7 including the union contracts, pension costs, and the legacy delivery system allowed the company to rebuild with a clean slate. Hostess’ main competitors include Flowers Foods, the maker of Tastykake, Grupo Bimbo, the maker of Entenmann’s, and McKee Foods, the maker of Little Debbie. Both Tastykake and Entenmann’s rely on direct store delivery and Little Debbie does as well, at least to a certain degree.This means that these competitors, especially Tastykake and Entenmann’s have a very different cost structure as compared to Hostess. For example, Flowers Foods operates 49 bakeries in the US (although not all of these are dedicated to SBG) and 37 of these bakeries distribute products via direct store delivery. Flowers has this to say about its direct store delivery approach:

o    “Flowers Foods is a leading producer of bakery products. Because fresh packaged bakery products have a limited shelf life, are fragile, and generate high retail turnover, it is a common practice in the baking industry to deliver direct to retail and foodservice outlets, known as direct-store-delivery (DSD). As in other industries where it is advantageous to deliver product directly to stores, manufacturers and distributors often work in close partnership, but each with their own incentives and motivations. DSD networks can take different forms, and Flowers' bakery subsidiaries use a common model similar to other franchise systems: The distribution network is segmented into geographic territories, and the exclusive distribution rights to sell certain products within a given territory is sold to unaffiliated, independent individuals and corporations. Since 1984, a significant portion of Flowers' products have been sold to and delivered by a DSD network made up of independent distributor territories. Today, Flowers' DSD network is made up of approximately 5,760 territories. Flowers' bakeries have sold the majority of these territories to approximately 5,200 independent distributors (IDs) who have the exclusive right to sell and distribute certain Flowers products within a defined geographic territory.

o    Because IDs own their own territories, they are highly motivated to increase their sales through outstanding service and merchandising. IDs have the opportunity to earn a return on their investment in two ways. First, they can generate additional revenue by increasing sales and controlling expenses. Second, because a secondary market for territories exists, the ID can realize the incremental equity value by selling all or a portion of their territories as they grow sales. The ID model is not unique to Flowers Foods. Many of Flowers' competitors in the baking business, other food businesses, and other types of businesses engage in similar business models. Flowers believes the ID model is a win-win where IDs, their customers, and the company benefit from the entrepreneurial incentive the model creates.” (http://www.flowersfoods.com)

Grupo Bimbo’s distribution is very similar to Flowers with over 60 bakeries, 22,000 employees, and 11,000 sales routes in the US. And even though they both use “independent contractors,” the resulting costs are much higher than Hostess’ warehouse method. Currently Flowers faces multiple lawsuits by drivers who claim they were improperly classified as independent contractors. Although it will be years before all the claims are resolved, if Flowers loses in court it would likely have to buy back the driver’s routes and trucks and classify them as employees.

Given the large number of bakeries, employees, and the direct store delivery, both Grupo Bimbo and Flowers have much higher fixed costs than Hostess. For example, over the last several years Flowers’ EBTIDA margins are in the low double digits compared to the high 20% range for Hostess. As a result, Hostess is very well positioned from a cost standpoint relative to its competitors. At least for Bimbo and Flowers, it would be nearly impossible for them to realign their cost structures like that of Hostess without going through something as drastic as a bankruptcy reorganization.

Going Public

After acquiring the Hostess assets in 2012, Apollo and Metropoulos reportedly began shopping the company in early 2015. According to news reports several companies including Grupo Bimbo, Flowers Foods, Aryzta AG, Post Holdings and several private equity firms made preliminary bids near $2 billion. However, Apollo and Metropoulos declined to sell, instead taking the company public via acquisition by a SPAC called Gores Holdings. Presumably Apollo and Metropoulos decided not to sell the company (and receive immediate cash) because they felt like Hostess was worth more than bidders were willing to pay. While Apollo took out some cash in the transaction, Metropoulos rolled over his entire equity stake and even put some cash into the business to help delever the balance sheet. (Prior to the transaction, Hostess had undertaken a dividend recapitalization in which the owners took out over $900 million in cash.) Currently Metropoulos owns over 24% of the equity. In addition to the business transformation undertaken at Hostess, I think one of the most interesting aspects of this idea is the continued ownership of Dean Metropoulos. Not only did he decide not to sell Hostess in early 2015 but he didn’t cash out in the Gores acquisition. In addition, he put cash into the business and decided to retain his position as executive chairman of the public company.

Mr. Metropoulos has a long and distinguished career as a private investor in numerous packaged food companies and brands including Chef Boyardee, Pabst Blue Ribbon, Bumble Bee, Ghirardelli Chocolate, and Pinnacle Foods. Historically his modus operandi has been to buy, improve, and sell, so it is out of the ordinary for him to remain an owner and chairman of one of his investments as it transitions to public life. Obviously, he saw something in Hostess that made him want to stick around.

Recent Events

·         In February of 2018, Hostess acquired the Cloverhill and Big Texas breakfast pastry brands along with a manufacturing facility in Chicago from Aryzta. Cloverhill and Big Texas brands include honey buns, cinnamon rolls, and Danish pastries with distribution strength in vending machines, convenience stores, and club. The acquisition also included several supply partnerships for private label. Previously Aryzta had been a co-manufacturer with Hostess. The plant is the largest individually-wrapped Danish manufacturing facility in North America. Hostess only paid $25 million for the assets however the business was losing money when Hostess acquired it and this business has been very detrimental to margins over the past two quarters. Much like for Hostess, the plan is to automate as much of the facility as possible however this won’t occur until later this year and it will require a significantly capital outlay this year. Ultimately Hostess expects the acquisition to produce $20 to $25 million in EBITDA by 2020 and it will allow Hostess to forgo internal capital investment.

·         On August 8^th, the company announced terrible results for Q2 as it cut EBITDA guidance from $225 to $195 at the midpoint due to several factors including a reduction in shelf space and promotional support from Wal-Mart, losses from Cloverhill, and greater than anticipated increases in transportation costs. Adjusted EBITDA fell to $47.6 million (22.1% of revenue) compared to $63.2 million (31.1% of revenue) the previous year. The stock fell 18% as the market was surprised buy the results as the company had expressed confidence in the guidance last quarter. Overall sales grew by 6.2% ($12.7 million) but that included $20.8 million from the Cloverhill acquisition. Excluding Cloverhill, revenue declined about 4%. The largest impact on margins came from a shift in mix from a decline in Hostess-branded products and a significant increase in negative margin Cloverhill business. The shift in product mix due to Cloverhill and small declines in branded-Hostess resulted in a 7% decline in gross margin. Wal-Mart accounts for approximately 20% of Hostess’ revenue.

·         Like other CPG companies, Hostess struggled with increases in shipping and transportation costs. On the Q2 call, the company said it plans price increases in the coming months to at least partially offset the increased costs.

Financials and Valuation

Prior to the 2012 bankruptcy, Hostess had revenue of approximately $1 billion and market share in the SGB category of 22%. In 2017 the company’s revenue totaled $776 million in 2016, up from $728 million in 2016. EBITDA margins for 2015 through 2017 ranged from a low of 28.7% to 29.7%. In 2017 levered free cash flow (FCF) including payments to minority interest totaled $118. Hostess has debt totaling $994 million under its term loan which does not mature until 2022. Based on the updated EBITDA guidance of $195, the company is levered approximately 4.4x on a net basis.

Shares: 131,600

Stock price: $12.14

Mkt cap: $1,598

Debt: $993.6

Cash: $135.7

Net debt: $857.9

EV: $2,456

2018 EBITDA: $195

EV/EBITDA: 12.6

Net Debt/EBITDA: 4.4

The share count includes the exercise of all outstanding warrants which were issued in connection with the initial IPO of Gores. Based on 2018 guidance of $85 million FCF and the current stock price, the equity is trading at a yield of around 5.3%. Based on 2017 FCF and EBITDA, the yield is 7.5% and EV/EBITDA multiple is 10.7.

Summary

While the Q2 results and remaining outlook for the year were quite poor, I believe the stock price reaction is overdone for several reasons:

·         A significant portion of the struggles last quarter were due to Cloverhill and the fact that $20 million in sales took place at a negative margin. Admittedly, management did a poor job of setting expectations; however, this is a situation that is fixable and will resolve itself in subsequent quarters as new equipment is installed and new processes are but in place. It has just taken longer than expected. With annual sales at Cloverhill at $80 million, if Cloverhill produced $20 million in EBITDA like Mr. Metropoulos has suggested, that represents an EBITDA margin of 25% which is lower than legacy Hostess business. In addition, if that goal is reached it would mean that Hostess only paid around 1x EBITDA for this business. Hostess knew Cloverhill lost money before they purchased it and I applaud it for purchasing something that was sure to suppress short-term results but would likely provide long-term gain. This is a company that Mr. Metropoulos was very familiar with. In addition, the equipment purchases for Cloverhill will suppress FCF this year, but capital expenditures should fall significantly next year. Assuming Cloverhill turns profitable and capital expenditures fall to historical levels, free cash flow is likely to be well in excess of $100 million on an ongoing basis and could be significantly higher within a couple of years. On the Q2 call, management expressed confidence on improvement in the second half of the year for Cloverhill and expects to be profitable by year-end.

·         The loss of promotional support from Wal-Mart is certainly negative for Hostess but it has managed its relationship with Wal-Mart for many years and Hostess will likely be able to work through this. Given the margin on the branded products, this is a mutually beneficial relationship and Hostess is the leader and fastest grower in the sweet baked goods category. Product sales to Wal-Mart should normalize, albeit possibly at a lower level, as the inventory reduction runs its course.

·         Although the company is levered over 4x, deleveraging should resume next year as the problems with Cloverhill are worked out and capital expenditures fall. Importantly, the company has time to delever as the first significant maturity is not due until 2022.

·         With Mr. Metropoulos owning 24% of the equity, he has significant skin in the game and his interests are aligned with shareholders. Given his track record, I’m willing to bet with him, especially at a price below $12/share.

·         Given the long history of the brand I think this episode is nothing more than a short-term setback. The Hostess-branded products have been around for decades and are in-grained in American culture. And although younger consumers may be more health conscious than older generations, snacking trends continue to increase and Hostess’ market share continues to gain.

Hostess has both common shares outstanding as well as publicly traded warrants (TWNKW). The warrants don’t expire for three years and at a current price of $2.76 (or $1.38 per warrant as one warrant is good for .5 shares) and a strike price of $11.50, the warrants are in the money above a common price of $14.26. In other words, the stock price just must rise by 18% at some point over the next couple of years in order to break even on the warrants. At a future stock price of just over $15 you are better off in the warrants than in the common at today’s prices. Given the time to expiration, I like the warrants relative to the common.

Catalyst

• Improvement at Cloverhill during the remainder of the year.
• Improvement in the Wal-Mart relationship and normalization of inventory levels
• Declining capital expenditures next year with improved free cash flow