Description

Thesis

THS is a stable, counter-cyclical business trading <8x cash flow. Cash flow should grow modestly over-time due to new product introductions, operational improvements and category growth. The company is 3.7x levered and has been using cash flow to reduce debt. This deleveraging is almost complete and THS should begin deploying cash to buybacks and M&A.

Business Overview and Background

Treehouse Foods is the largest producer of private label food in the US. 90% of sales are to food retailers with the remainder to the food service and industrial markets. The company is the largest private label supplier to all the major supermarkets in the U.S. and most of the largest restaurant chains. Wal-Mart is the largest customer accounting for 24% of sales and the top 10 customers account for 58% of sales. Meal solutions (basically anything you would use for cooking) accounts for 44% of sales, baked goods are 34% and beverages are 22%.

For many years Treehouse was a roll-up story culminating with the 2016 acquisition of Ralcorp from ConAgra for $2.7B. This was a huge deal and integration was difficult. Operational issues lead to decreased margins and poor customer service. THS started losing contracts and by early 2018 shares were 50% below the price when the Ralcorp deal was announced.

In 2018 the current CEO Steve Oakland joined with the goal of improving margins and customer service.  Oakland hired a new executive team, sold several divisions and discontinued product lines. These efforts appeared to yielding results as shown in Figure 1 below.  At the beginning to the year management said the company’s restructuring efforts were complete and sales would grow organically in the second half of the year (the contracted nature of this business means its takes about 12 months for improved customer service to show up in sales).

Since March, Treehouse has benefited from increased supermarket traffic. However, COVID also impacted operations during Q2, increased certain costs and allowed branded products to gain share over private label. Retailers temporarily suspended adding new private label products while they tried to handle the unexpected traffic surge. As such, COVID has obscured much of the progress THS made even though the underlying business appears to be improving.

Figure 1: Treehouse’s Service Levels

Commodity Business with Scale Advantage

Treehouse Foods is commodity business in a highly fragmented and competitive industry. Despite the commodity nature of this business Treehouse’s return on tangible invested capital over the last 10 years are >15%. Strong returns are due to the company’s scale advantage. Treehouse is the largest player in private foods by a wide margin. THS is multiples larger than the next biggest competitor and is #1 in 17 out of 29 categories. In these 17 categories THS’s average share is above 50%. Treehouse’s scale allows it to buy larger quantities of raw materials and operate larger facilities than competitors. More importantly, scale provides logistical advantages. Treehouse has 36 manufacturing plants across the country which allows them to produce products closer to customers. Since they supply a large variety of products to many customers they are able to ship their customers full truckloads more frequently. Treehouse’s customers er spoke with confirmed that this allows for lower distribution costs and lower inventory levels.

Figure 2: Treehouse’s Scale is Unique in this Industry

A Growing, Counter Cyclical End Market

Private label products account for 18% of US grocery sales up from 13% in 1989. Penetration continues to increase about 30-50 bps per year and there are several reasons to think this trend should continue. In many European countries private label penetration exceeds 40% in large part to discount chains such as Aldi and Lidl. Aldi is adding 500 US locations over the next 2 years. Lidl opened their first U.S. store in June 2017 and will have over 150 by the end of 2021. Additionally, younger consumers tend to purchase more private label products than older shoppers; A 2017 study showed 51% of millennials had no preference for branded products vs only 38% for boomers.  Private label penetration also tends to increase in recessionary periods as consumers try to save money. As such, negative macroeconomic changes are actually a positive for Treehouse.

Why is the Stock Cheap?

There’s got to be a reason a consumer staples stock trades at 8x cash flow. For THS there are three fundamental reasons the stock trades where it does:

Quarterly volatility – This is a company that can totally whiff a quarter which makes it difficult for many people to own. Promotional activity by branded competitors or customers can impact sales volume in ways that are beyond Treehouse’s control. Changes in demand can further impact the company’s complex production and distribution network leading to margin pressure beyond the simple impact of lower sales volumes. Management has talked about new systems and greater integration with customers to allow for better forecasting. However, THS investors have to be comfortable with a certain level of quarterly volatility.

Recent market share trends – Shares are down over 20% since the beginning of June when scanner data started to show THS’s private label categories losing share vs branded products. This is largely due to a shift towards a stronger consumer (personal income +10% yr/yr in Q2) who was food shopping as a substitute for eating out whereas private label penetration is greater with value-focused customers. Also, to cope with the demand surge Treehouse’s customers reduced SKUs and focused on standard-size packaging which favors brands over private label. Bottom line here is this any share loss is entirely COVID-related and does not signal a fundamental shift in consumer preferences.

Figure 3: Recent Market Share Trends

Credibility – THS shares are >50% below where they traded during 2016/2017. The company has a credibility problem with investors. New management seems to finally understand they need to meet their guidance and deliver clean results. For now, most investors remain skeptical and the Treehouse needs to work to regain investors’ trust.

Strong Returns Using Conservative Assumptions

At 8x cash flow, THS should deliver strong returns if cash flow growth is greater than or equal to zero. Cash flow should grow modestly over-time for the following reasons:

Category growth – As discussed, private label should continue to grow for many years. While Treehouse’s offerings in aggregate may be expected to underperform broader private label growth, category growth should still be a modest tailwind for Treehouse.

New products – Treehouse is newly focused on working with customers to launch new products in fast growing categories. By example, next year will feature the expansion of the ready-to-drink cold brew coffee line which should help growth.

Operational improvements – Management has stated that over-time there are several opportunities for margin improvement through improved operations. While it is difficult to specifically diligence these claims, some amount of margin improvement seems reasonable.

As shown below, even if you only assume 1% organic growth, with minimal operating leverage and an 11x terminal multiple you still get a 17% IRR at today’s price.

Figure 4: THS Expected Returns

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Catalyst

Deleveraging, buybacks, return to organic growth