Morningstar | Disappointing 2Q Does Not Suggest a Change in Hostess' Long-Term Prospects
While our $15.40 per share valuation for narrow-moat Hostess should see a high-single-digit percentage dip in the wake of its second-quarter earnings, the poor results do not alter our long-term view. As we believe many of the headwinds that led to the shortfall are transitory, we still assume low-single-digit top-line growth and mid-to-high-20s adjusted EBITDA margins on average over the next decade. Despite the planned cut, we see the shares as somewhat attractive.After first-half sales grew 9.5% but adjusted EBITDA margin fell nearly 810 basis points (to 22%), management cut its 2018 guidance to $190 million to $200 million in adjusted EBITDA and $0.52-$0.58 in adjusted diluted EPS (from $220 million to $230 million and $0.65-$0.70, respectively), lagging our $220 million and $0.68 estimates.
The results were weak, but we believe the headwinds are fleeting. Foremost, Hostess encountered transportation and input cost inflation (like most packaged food companies recently). Management indicated it has not yet raised prices in response as it wishes to first develop a comprehensive strategy that considers promotions and everyday levels. We believe the near-term slump will yield to performance improvement into 2019 as hikes take hold, particularly as we contend that Hostess' products have pricing power, demonstrated by their roughly 30% historical premium over the category. In addition, the firm suffered from reduced promotional support at one of its largest retailers (we suspect Walmart, which yielded over 20% of 2017 sales). Management suggests its recent merchandising discussions indicate the losses will reverse, with back to school season spurring recovery. In particular, leadership indicated the regained support would come at no incremental cost, which we believe reinforces our view that the firm benefits from retailer relationships borne of its brands' standing and ability to command premium prices that enable higher retailer margins than rivals.
Hostess Brands is a packaged food company. The company produces Hostess?, Dolly Madison?, Cloverhill? and Big Texas? products at bakeries located in Emporia, KS; Columbus, GA; Indianapolis, IN; and Chicago, IL. In-store bakery products are produced at bakeries located in Southbridge, MA. The company has invested in baking and packaging technology, including installing two Auto-bake systems and fully-automated packaging systems. A portion of the company's products are co-manufactured and packaged under its brands and sold through its distribution facilities. The company's Direct-to-Warehouse distribution model uses centralized distribution centers and common carriers to fill orders, with products.
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