Description

We are long TreeHouse Foods (THS) which is the largest of manufacturer of private label food products in the US.  From a macro point of view an increasingly competitive environment in grocery retail and the continued expansion hard discount formats (Aldi/Lidl) is leading to a secular share shift from branded foods to margin accretive private label, this trend has accelerated over the past 18 months.  Despite the fact that THS should have been a benefactor of this trend the stock has gone from a high of $90.00 in 2017 to $38.00 today due to a combination of input cost inflation, a botched integration of the largest acquisition in their history, and poor management.  We think the stock more than doubles over the next 12 months to our target of $86, the thesis from here is:

• Investors are confusing cyclical issues for secular challenges  

  • Admittedly this is a mediocre quality manufacturing business with no brand equity, so when COGS spike they have to reach out to customers to get price, the clients push back, there is some back forth, and historically they eventually recover what they need with a lag.  Since mid-2016 they have been fighting inflation which accelerated in the 2H of 2017 and has been made even worse with the freight spike of early 2018.  They have reportedly been successful in their efforts to reprice their book and guidance for 2018 accounts for additional inflation in the 2H per the current future curve.

  • Just like most other disaster stocks there is always secular fears sprinkled on top of cyclical issues.  In private label foods it is currently the notion that the industry is has too much capacity and Mom and Pop players are becoming irrational with price.  We attended the Private Label Manufacturing show last fall in Chicago and effectively heard from almost everyone we talked to that it was business as usual (ie, competitive now just like it always has been) and that it seemed like THS’s issues were unique.

• The stock is way too cheap here at 8.5x 2019 cash earnings (our estimate is $4.50)

  • Also consider that the #2 player Ralcorp used to be public, it was bought in 2013 by CAG for $7B (13x EBITDA) who then sold it to THS in 2016 for $3.5B.  The integration has been a nightmare, but the current EV of THS is $4.6B vs the combined EV of THS/RAH in 2013 of $11.2B.

• The company announced Steve Oakland from SJM as its new CEO earlier this month.  Our checks have been very positive and he is a well respected industry veteran with experience in operations, acquisition integration, and has worked previously in the categories that THS plays in.

• For those worried about the economic cycle being long in the tooth it’s a pretty stable business that tends to be a bit countercyclical as consumers trade down to lower price points in a recession.  Top line grew in 2008/2009 and the stock was up both years (it actually closed out 2009 at $35/share, not too far from today’s price).

• Sell side analysts now hate it after pumping it long for the past five years.  It got four downgrades last fall when it missed Q3 earnings and the stock fell close to 40%.  Our initial experience with THS was on the short side when GMCR got aggressive going after private label K-Cup business, back then it was the only “secular growth” story in food and traded at 20+ times earnings, how times change even when the structural business really doesn’t…..

Note:  The CPG space over the past three months has been terrible as investors fret about the inflation factors mentioned above, if you are uncomfortable with this risk we would recommend shorting a basket of branded food companies as a hedge.  Not only are they volume share losers but their EBITDA margins are on average about 1000bps higher than THS, if you’re WMT and you’re looking for fat to eat into in terms of P&L the branded guys are much easier targets.

THS and Private Label

THS was spun out of Dean Foods in 2005, it is the largest private label food manufacturer in the country.  We're not going to go too deep into the business description as they have a ton of slide decks on their website which lay it all out.

As for the private label industry itself, growth is being driven by:

• Retailers realizing higher gross profit dollars at a lower price point for the consumer (We won’t start listing quotes here but they all harp on it during conference calls)

• Discount formats such as Aldi/Lidl expanding in the US and taking share, private label represents 85-90% of their mix

• Younger consumers care less about brands

Given the above why has the stock been such a disaster?

Put simply, they missed numbers four quarters in a row and saw two COOs leave due to the difficulty integrating the Private Brands (RAH) acquisition.  Its impossible to say what percentage of the issues were integration related vs difficulty in the core business but after speaking with management and others in the industry our best guess is 50/50.

Breaking down the core business softness:

• As the chart below indicates they have faced COGS inflation since 2H 2016, they have been playing catch up with pricing and its hit their gross margins

• There was an uptick in competitive activity in early 2017 which has since died down, this was broad based but GMCR did try to get more aggressive again and won WMT’s business back in K-Cups

The only solution to this is taking price, which historically they have been able to do with a 1-2 quarter lag.  The majority of their book is out for repricing at the moment and we have been told that early feedback has been positive.  Because THS is transparent with the bill of materials with their customers and the margins of the business are so thin relative to the branded guys there is really nothing to conceal and they are able to point out line by line where there are seeing pressure (or getting relief in which case they give it back to the customer).

As it relates to the integration of Private Brands there are a number of factors to consider. 

• We think the biggest factor is the outgoing CEO Sam Reed, he was a pioneer in rolling up the private label industry and quite frankly did a great job until he started trying to do deals that were significantly larger than the tuck-ins he was so good at.  Flagstone which he purchased for over $1B in 2014 was the beginning of the end (Goodwill was written down to $0 on the last quarter).  Sam is now in his 70s and THS is his baby but we don’t think he knew how much heavy lifting was going to be required to integrate Private Brands and had no experience with deals of that size.  Since the deal he has hired and then fired (this is debatable) two COOs in the span of a year because they weren’t following his guidance closely enough (again, debatable).  Now THS will have a veteran CEO with integration experience that will be free of Sam’s watch and will have the best shot at turning the boat around.

• The other issues have been more plain vanilla operational difficulties

  • Salesforce streamlining

  • SKU rationalization/overlap

  • Pricing management

  • Systems integration (ongoing)

  • Manufacturing footprint rationalization (ongoing)

Net net, we think the normalized EBIT margin profile of this business is conservatively 200-300bps higher than were they ended 2017.  Both historical THS/RAH financials would demonstrate this is pretty conservative even before any potential cost synergies after the streamlining of the two businesses.

The new guy

We’ll keep this brief but we think Steve Oakland is big win for THS.  He is a 35 year industry vet who ran the US foods business for SJM.  During his tenure he oversaw growth through M&A in the pet and coffee categories, portfolio trimming in the milk business, and numerous supply chain initiatives (plant closures, etc), all of which are relevant to THS’s current situation.

Conclusion

We think at normalized margins THS will produce $6.00 of cash earnings (fully taxed, backing out amortization).  If the secular growth of private label continues and they get operational leverage out of a rationalized manufacturing footprint this number will be conservative.  In that scenario we would guess the stock re-rates back to its historical 20x multiple and would be a triple from here.  In the meantime we’ll settle for the opportunity to buy a decent business for 8.5x cash earnings with expectations completely bombed out and a new CEO about to take the helm.  FCF was $6.00/share in 2017 and should be around $5.00/share in 2018, you’re getting a FCF yield of 13% while you wait that they will use to delever and buyback stock once leverage hits their target.

Risks

-Steve resets guidance on his first earnings call

-inflation continues to accelerate

-Private Brands integration improvements fail to come through

Catalyst

-lack of future guide downs

-future supportive private label industry share theft