Morningstar | Narrow-Moat Hostess Faces Inflationary Pressures, but Brand Strength Is Intact; Shares Attractive
We expect to make a low-to-mid single-digit cut to our $14.10 per share valuation for narrow-moat Hostess after it posted lackluster third-quarter earnings. Most of the change will stem from alternations to our short-term outlook, particularly as recent price increases to offset inflation are only just hitting retail and will take time to boost profitability. We believe the causes of Hostess' soft quarter are transitory (price lags, the ongoing turnaround of its newly-acquired breakfast assets) and maintain our long-term outlook (low-to-mid single-digit sales growth, mid-20s adjusted EBITDA margin over the next 10 years, on average). Despite the planned cut, we see the shares as attractive, and believe sentiment underestimates Hostess' brand strength.Year-to-date sales rose 10%, but adjusted EBITDA margin fell 850 basis points (to 21%) as cost inflation, which has affected most food manufacturers, strained profitability. Management cut its 2018 guidance to $185 million to $190 million in adjusted EBITDA and $0.52-$0.55 in adjusted diluted EPS (from $190 million to $200 million and $0.52-$0.58, respectively), near our $189 million and $0.53 targets.
We are encouraged by management's commentary that the low-single-digit price hikes it is enacting to offset inflation have been well received by retailers. The reception is not a surprise; Hostess has long priced at a premium to the category, and we believe the retailer reaction is indicative of the brand strength underlying our narrow-moat rating.
Hostess' progress in turning around its recently-acquired Cloverhill unit (despite its as-expected $5 million quarterly adjusted EBITDA loss) is similarly heartening, particularly its recent launch of Hostess-branded breakfast items. The new lineup, as well as recent innovations in legacy products and the success of the premium Bakery Petites portfolio, suggests that Hostess can leverage its premium position in new categories and upmarket, consistent with our thesis.
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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