EUR 850.00 For Business Accounts Only

Morningstar | Sweet Quarter for Narrow-Moat Hostess; We Now See Limited Upside in Shares

We don’t expect to materially alter our $14.40 fair value estimate for narrow-moat Hostess, as first-quarter results largely aligned with our outlook. However, the discount to our valuation has compressed as shares popped in the mid- to high-single-digits in pre-market; we suggest investors await a more attractive opportunity to build a position.

After three quarters of flat or declining organic growth, revenue bounced back, to the tune of 3.5%, driven by a 2% bump in pricing as well as the benefit from new Hostess-branded breakfast items and expanded distribution . We remain confident in our 3.5% organic revenue estimate for fiscal 2019, as Hostess is poised for further distribution gains in new channels and categories, given the inherent strength of its namesake brand. However, once the brand has regained the distribution lost during its hiatus, we expect growth to decelerate to 1.5% long term.

Consumers are shopping even more channels. And although club is still a small channel for the firm (we estimate mid-single-digit percent of revenue), it is realizing impressive growth, which has been facilitated by the Cloverhill acquisition. Hostess has leveraged this by launching Hostess-branded products into these stores, resulting in a 78% surge in club point-of-sale growth during the quarter and 870 basis points in channel share gains to 20.5%. Hostess’ ability to create shareholder value from its shrewd tie-up strategy is one of the drivers of our exemplary stewardship rating.

Hostess isn’t merely driving growth at any costs but is keenly focused on profits. Adjusted operating margins were 17.3% in the quarter, 30 basis points below the year-ago period (primarily due higher commodity, transport, and logistic costs). Despite this near-term pressure, we expect margins to expand to 19.3% in 2020 and 21% in 2021 and beyond, as the firm continues to overhaul the Cloverhill acquisition (extracting inefficiencies that had it operating at a loss prior to the tie-up).

Hostess is ramping up its marketing capabilities in order to deliver on its goals regarding continuous innovation, sharpened analytical capabilities, and consumer and customer insights. We applaud the firm’s heightened focus on these initiatives, which should help keep its competitive edge sharp in a competitive marketplace. Hostess has historically spent 4% to 6% of revenue on marketing, in line with its packaged food peers but below wide-moat Hershey’s 7%. Going forward, we expect Hostess’ marketing investment to gradually increase, mirroring Hershey’s investment level. As a part of these efforts, in April, the firm announced it hired Chad Lusk as senior vice president and chief marketing officer, a veteran of the consumer products marketing field, including the Ferrara Candy Company, undoubtedly relevant experience. The firm also announced the opening of a new office in Chicago, which will serve as its new hub for marketing and category management.