Hostess' baseline business benefits from 90% brand awareness and strong profitability.

LITTLE ROCK, ARK. — Hostess Brands, Inc. will take advantage of numerous avenues for growth in coming years to the considerable benefit of investors, said Farha Aslam, an analyst with Stephens, Inc., Little Rock.

Farha Aslam, an analyst with Stephens, Inc.

“Hostess in our view is in the early stages of a recovery under a very strong leadership team following Chapter 7 bankruptcy,” Ms. Aslam said in a 35-page report initiating coverage of Kansas City-based Hostess Brands. Ms. Aslam rated Hostess “overweight” with a price target of $20 per share, based on a 14- to 15-time multiple of forecast 2018 earnings.

With strong free cash flow to pay down debt, Hostess is well positioned to make acquisitions in the sweet baked foods category, Ms. Aslam said. The company’s baseline business benefits from 90% brand awareness and strong profitability.

“Hostess has a best-in-class financial position with ~29% EBITDA margins and ~86% free cash flow conversion,” she said. “Margins benefit from the premium pricing Hostess products command given the company’s iconic brands. Furthermore, the company emerged out of bankruptcy with a lean cost structure with no burdensome legacy pension obligations and union contracts. Products are now produced in three bakeries on state-of-the-art production lines given a $150 million capital improvement project. Margins are also benefiting from a differentiated distribution model.”

While pre-bankruptcy Hostess operated 12 cake plants, many of which produced the same items and faced labor issues, the company currently operates three baking plants with heavily automated lines while using co-packers for unique products.

The recovery marks an amazing turnaround following emergence from bankruptcy in 2013. In November 2016, Hostess shares began trading on Nasdaq.

Looking ahead, Ms. Aslam sees three paths for innovation to be pursued by Hostess:

1. Complementing the existing product line with classic products not yet launched or entirely new products in the sweet baked foods category where Hostess is not yet active;
2. Launching line extensions;
3. Unlocking new customer segments with new benefits and/or occasions; and
4. Expanding into new categories.

Additionally, Hostess still has progress to make toward regaining market share lost as a result of bankruptcy (17% current share versus 23% before bankruptcy) and by expanding into new categories, including in-store bakeries (I.S.B.).

In addition to its prodigious size ($8 billion in annual sales), the in-store bakery category is growing about 7% to 8% per year, Ms. Aslam said.

Desserts and sweet snacks account for about 70% of (I.S.B.) sales and as a result is “well suited for Hostess’s core brand equity of sweet goods,” Ms. Aslam said. Additionally, because 70% of I.S.B. sales are private label, an opportunity to establish a branded presence may be at hand, she said. For Hostess, I.S.B. is a platform for organic growth and acquisitions given its high fragmented market structure, she said.

With these strengths, Ms. Aslam is projecting sales growth of 7.9% in 2017 and 6.3% in 2018. EBITDA growth should reach 10% in fiscal 2017 and 9% in 2018, she said.