NEW YORK — Vertical Group on May 21 initiated coverage of Kansas City-based Hostess Brands, Inc. with a “buy” rating and a $19 price target (versus a May 21 closing price of $12.85).
“Hostess has transformed itself from the days of old and today is a growing, high margin business capable of future M.&A. into adjacent snack product areas,” Brett Hundley, research analyst, wrote in a May 21 report. “We really like this company’s culture of winning, its focus on innovation and white space development, and its management of the consumer and the investment community. Although we see potential for competitors to become more focused, themselves, going forward, we like (Hostess Brands’) positioning and its ability to act with purpose on forward M.&A.”
In initiating coverage of Hostess Brands, Vertical Group identified a few key points behind the move. First, the company’s transformation, which Mr. Hundley noted has been a result of new management that has taken the company from “an extremely inefficient baked goods operator with O.I. margins in the (low-single digits) and transformed it into a highly efficient operator with O.I. (operating income) margins in the 20% to 25% range.”
“The company acts and reacts quickly, managing the consumer and investor community very well,” Mr. Hundley said. “We think it is deserving of a far better valuation multiple than that received today.”
A second key factor has been the company’s growth strategy. Mr. Hundley said Hostess Brands’ management is focused on building upon the strength of the Hostess brand and should be able to deliver strong growth. The company also seems poised to leverage its solid cash flow and penchant for turning around businesses as it looks to conduct value-enhancing M.&A. into adjacent snacking and baked foods areas in the years ahead, he said.
Vertical Group estimated earnings per share of 68c and 85c in fiscal 2018 and fiscal 2019, respectively, which the ratings agency said may prove conservative.
"Simply, this is a company of action, relative to its peer set that has been ... rather lethargic to date." — Brett Hundley, Vertical Group
“We admire (Hostess Brands’) turnaround, along with its focus on category/brand building through innovation and marketing, along with its pursuit of white space distribution/opportunity,” Mr. Hundley wrote. “Simply, this is a company of action, relative to its peer set that has been, well, rather lethargic, to date. We expect the company to continue to outpace sweet baked goods category growth ahead, despite the potential for a better competitive stance from peers, along with the continued pursuit of health and wellness by consumers. In addition, we think that (Hostess Brands) will be active on the M.&A. front, and we think that the latter can unlock hidden value in underperforming assets currently owned by other managers/entities. Some now refer to such an impact as the ‘Hostess effect.’”
Despite the optimistic outlook for Hostess Brands, Mr. Hundley did point to several risks that could affect the company’s ability to deliver on the stated price target. Risk factors he cited include a rising raw material environment, consumer pursuit of healthier food/nutrition labeling, policy change/product tax, improved competition, product recall/health scare, greater retail price pressure, ownership structure change and facility concentration.
Another potential risk factor that may be lurking is a lack of success in the in-store bakery category.
“A stated strategy of Hostess is to consolidate and expand within the in-store bakery area of retail grocery,” Mr. Hundley said. “This part of the store has been growing faster than center-of-store areas, in part due to perceptions over quality and health. (Hostess Brands) has already made one asset purchase in the space (Superior Cake Products), and we believe that it will look to complete other deals going forward, as well. We believe that the I.S.B. category is a much different production/sales process, relative to the company’s core branded cake business. In fact, we believe that I.S.B. very much mirrors that of a private label platform; traditionally, the management of private label and brands together has not worked well for companies. We worry about the allocation of capital and other resources to an I.S.B. area that may not offer sufficient returns (margins/R.O.I.C.), along with s.k.u./customer proliferation that could further weigh on segment results.”