SPAC’s Never Tasted So Good … Hostess Brands, Inc. Analysis

“Know what you own, and know why you own it.” – Peter Lynch

Most of my job as an investor is to understand the businesses that I own; and if I’m lucky, to understand those businesses better than those selling their shares. Since I spend most of my time in the smaller, illiquid spaces of the markets, most of my time is spent understanding these businesses and the value they create for their customers because I haven’t necessarily even heard of such companies before finding them on screeners, or what not. However, this one is different. Say the name, “Hostess” and almost every single American can tell you at least one product they make. This magnitude of brand power shouldn’t be discounted, however, the market seems to have done just that. Trading at 6x earnings, 10x FCF, and sporting industry leading margins, TWNK is a misunderstood SPAC with tremendous brand power with the ability to price its goods at a premium to its competitors, giving it a durable competitive advantage that leads to a 17% market share (and expanding) in baked goods.

Hostess Brands (TWNK) is the packaged goods food company that manufactures and sells delicious baked sweet goods in the United States. The company is the second largest producer of sweet baked goods in the US, cranking out products such as Zingers, Sno Balls, Ding Dongs, Ho Hos, Donettes, and yes, Twinkies. Although its treats are sweet, the company’s history as a public enterprise is less desirable. Bankruptcy hit TWNK in 2012, forcing the company to become insolvent. However, in 2016, the brand Legacy Hostess was acquired by Gores Holdings in 2016, and then as a SPAC became public as Hostess Brands, Inc. The history makes the research a bit sideways. At one end, the company itself has been around for hundreds of years, cranking out delicious goods every year. Yet on the other end, the company is not even 3 years old in its publicly traded life.

Business Deep Dive

I don’t have to go too deep into the history of the business, mainly because anyone reading this already knows what TWNK does, what they make, and how damn good their products taste. The company was founded in 1919 when Hostess introduced its CupCake. I do want to spend some time going into the weeds in regards to the SPAC situation. The company does a great job walking through the steps in their latest Annual Report, so most of the information in the following paragraphs will be from their 2017 10-K.

Hostess Brands was originally a Delaware Incorporation in 2015 as a SPAC formed for the sole purpose of effecting a merger, asset acquisition, stock purchase, or other similar business combination with one or more target businesses. In August of 2015, Gores Holdings delivered the IPO, following which its shares began trading on the NASDAQ under GRSH. This is where things start to get a little “weedy”. In November 2016, Gores Holdings acquired a controlling interest in Hostess Holdings, L.P. Hostess Holdings had acquired the Hostess brand and certain assets out of the bankruptcy liquidation process of its prior owner, free and clear of all past liabilities back in April of 2013, and relaunched the Hostess Brand later in 2013. Gores Holdings then changed its name to Hostess brands, Inc. and its trading symbol from GRSH to TWNK.

A Corporate Makeover

Since reviving from bankruptcy, the company has poured over $200MM to upgrade their manufacturing facilities, implementing new IT systems, and enhancing production efficiency through the installation of automated baking and packaging lines. The company believes that these investments, coupled with their Direct To Warehouse Distribution model, put TWNK in the driver’s seat for increased revenue growth as well as consistently expanding margins. What makes the DTW Distribution model so much better than say Direct to Store?

The DTW model uses centralized distribution centers and common carriers to fill orders, with such products generally delivered to the customers’ warehouses. This means that the DTW model eliminates the need for a Direct To Store delivery system, which requires much more infrastructure to support (more routes, more drivers, more money spent). This extra cost savings has allowed TWNK to expand their core distribution while gaining access to new channels (read: Win-Win).

4 Pronged Attack Plan for Growth

Hostess outlines four strategic initiatives in order to achieve maximal organic growth:

1. Core distribution expansion
2. Innovation
3. Expansion of “White Space”
4. Platform for Future Acquisitions

Core Distribution & Innovation

Core Distribution Expansion (mentioned above) comes from the ability to take advantage of the DTW Distribution model, while adding to top line growth through various avenues such as expanding points of distribution, increasing SKU assortment, and recapturing shelf space in existing retailers. TWNK’s top three products (Donettes, TWinkies, and Cupcakes) have All Commodity Volume distribution rates in the core channels that are significantly higher than average rate of its competitors.

On the Innovation front, the company has made efforts to grow organically through two main efforts: 1) Launching of Hostess Bakery Petites, and 2) Acquisition of Cloverhill Bakery. Hostess Bakery Petites is a premium snacking platform made with no artificial colors or corn syrups. This is a good sign because as an investor I want to know if management can recognize a change in an industry. In this case the industry is moving away from processed / artificial ingredients in favor of more natural, organic material. TWNK seems to recognize this shift and is acting accordingly.

The acquisition of Cloverhill puts TWNK in a strategically advantageous spot to start taking market share in the breakfast space. Since Cloverhill was burning through cash at time of acquisition, the company was able to purchase all assets for quarters on the dollar.

White Space Expansion & Future Acquisition Platform

The company is seeking to grow its ISB presence in the grocery and club market channels. The company says its had early success with licensing in frozen foods and continues to expand into food service through its national distributor relationships. On top of that, the company is now packaging foods for sale in Mexico, the UK, and Canada through various third parties, increasing its brand presence and revenue potential outside the United States.

The company is optimistic on the future of its acquisition capabilities citing the following reasons: an experienced management team, economy of scale, access to capital, brand leveraging. With these components in hand the company believes they can achieve acquisitions on small and large-scale and integrate such acquisitions seamlessly into the scale of the business.

Sustaining a Competitive Moat

The brand Hostess is a natural moat, but in order to sustain growth and dig that moat deeper, TWNK needs to capitalize on that already existing moat. The company has the mechanisms in place to do that. First, the company has an 80% premium price point over the category leader. This helps TWNK expand their margins and generate higher and higher cash flows over time.

TWNK is trading at 6x earnings, 1.7x Book, and 10x FCF. The company has an Earnings Yield of close to 17% and is generating a FCF Yield of 8%. Margins are solid as well. Gross Margin at 40%, EBIT Margin at 25%, Profit Margin at 29%, and FCF Margin at 17%.

Finding Fair Value

TWNK’s revenues have grown (on average) close to 10% CAGR since 2015. If we project revenues to grow (on average) close to 7-8% for conservative estimates, and take into consideration the company’s historical EBITDA Margin % of 27%, it would leave us with revenues of $1.05B and EBITDA of $338MM by 2022. From this we can get our unlevered FCF by subtracting D&A and Taxes to get our Net Operating Profit After Tax of $258MM. Taking this number, we need to subtract CapEx and NWC Investments, while adding back our D&A. The final result gets us FCF of $233MM, or an annual average FCF growth rate of 13%.

Adding up all the FCF’s for each of the five years projected we get a PV of Discrete Cash Flows of 943. Taking a revenue multiple of 2.5x we get Terminal EBITDA of 1,034. With a terminal discount factor of 72% we end up with PV of Terminal Value of ~2,268. Combining both the cash flows and terminal values gets us a rough estimate of Enterprise Value between $2.3B and $3.2B.

Now that we have our Enterprise Value, we add in cash and subtract any debt. The result gives us value of common equity between $1.46B and $2.315B. Taking those numbers we can divide them by the number of shares outstanding, which is 129MM. This gives us a range between $12 – $18.

Reading The Tape

This is a great looking chart. You can see the consolidation / squeezing going on right now, and a the crucial price level of around $14. I’ve already started accumulating shares while it’s in consolidation. This is a starter position, and if price breaks above $14, I will add significantly to my already 70bps risk position. I have my stop – loss set at $10, which should give the stock enough room to wiggle around and not shake me out of an early decline in share price.

Where is My Fallibility?

1. TWNK fails to capitalize on its branding moat and gives up more market share over the next 1 – 2 years. This is a small concern because Hostess came out of bankruptcy and was two steps back from where it was, giving up market share in its absence. This risk is mitigated by the company’s acquisition of Cloverhill, which shows me that they are committed to gaining that lost market share, while at the same time looking to expand into new territories (like breakfast foods).
2. Americans really actually care about eating healthier, and thus reduce the demand for sweet treats such as Twinkies, Ho Hos, and oatmeal pies. If you take a look at the southern United States, this risk is harder to believe than most, but it’s still true. There is a sweeping wave of healthy eating in America, and its backed by lots of government dollars. If Americans stop choosing unhealthy snacks, it would take a serious hit to TWNK’s bottom line.
3. The food consuming market is becoming specialized. Private label companies are gaining ground on big names like TWNK, threatening the ability of a company like TWNK to charge a premium on their product, especially the baked goods section. I know this first hand because there’s a killer bakery near Downtown Annapolis called Great Harvest that makes tremendous baked goods. The reason I bring this up is because I can see people justifying paying a premium for a “local – homegrown” baked good rather than a big brand named good.

Once again, I am long TWNK at an average cost basis of $13.87, risking a total of 70bps of capital in my paper trading account. I will look to add to this position as price continues to head in my favor. Stops are set at $10.