With Scale, Flowers Foods Has Built A New Future For Itself

By Stephen D. Simpson, CFA | August 14, 2013 AAA

Tech investors may turn their noses up at consumer staples companies as hopelessly low-growth and boring, but Flowers Foods (NYSE:FLO) is a good example of what a prudently aggressive management team can accomplish. In 2000, the company served about one-third of the country; now that figure is up over 75% and the company has yet to focus on the Midwest and Pacific Northwest regions. Along the way, Flowers blend of organic and acquired growth, scale, and operating leverage has produced nearly 9% compound revenue growth and almost 15% free cash flow growth. That, in turn, has fueled one-year, five-year, and 10-year stock appreciation of almost 70%, 100%, and 500%. While I'm not calling for an end to Flowers gaining share or growing its business, I do wonder if the shares aren't in need of a little rest, as the valuation no longer seems quite so compelling at these levels.SEE: Earnings: Quality Means Everything A Good Quarter, With Hostess On The WayFlowers reported revenue growth of 32% in the second quarter, good for a roughly 5% beat relative to sell-side expectations While the much-publicized Hostess deal actually closed after the quarter, Flowers nevertheless still saw significant acquisition-related impacts in this quarter. Reported volume increased nearly 22%, with about 11% of that from acquisitions. Price/mix was less favorable (down 1%), but organic growth of roughly 10% for a food company is pretty exceptional. Contrary to what we often see, Flowers didn't suffer much margin pressure from those deals. Gross margin actually improved more than a point, while operating income jumped 58%. Even with adjusted operating income rising 62% and adjusted operating margin expanding by 170bp, the unadjusted figures (58% and 130bp) are quite good in their own right and speak to the benefits of increased volume, scale, and operating efficiency. Not Bad, But Nearly NationwideWith apologies to ZZ Top, Flowers Foods is well on its way to being both good and nationwide. The acquisition of Sara Lee and Earthgrains brands in California brings this huge state fully into play and takes the company from about 70% U.S. population coverage to 77%. And it's worth noting that this deal is really only a foothold – as leveraging the company's snacks and cakes businesses will follow. At the risk of oversimplification, baked goods is a business that comes down to brands and scale. To that end, Nature's Own, Cobblestone Mill, Sunbeam, and Tastykake can stand toe to toe with Grupo Bimbo's Arnold, EarthGrains, Entenmann's, and Thomas on the store shelves, not to mention Campbell's (NYSE:CPB) Pepperidge Farms and a host of private and store brands. Moreover, through the acquisition of Hostess' bread business, Flowers will be added well-known names like Wonder Bread and Nature's Pride in a $355 million deal. Scale is also increasingly important. Not unlike the brewery business, baking business run better when a company can operate a relative limited number of facilities running all-out with regular local/regional distribution. With the 20 bakers coming with Hostess, Flowers will have 64 bakeries in operation, with around 80% delivering directly to stores. At the same time, though, Flowers has improved its efficiency from roughly 88% to 93% between 2008 and 2013 – an increase that the company claims is equivalent to more than two entire bakeries. Given the inefficiencies at Hostess (which I assume, given that bankrupt companies are seldom highly efficient), the opportunity to drive even better utilization and margin improvement should be a powerful earnings and cash flow driver. More On The Way?While I think Flowers is going to need time to digest the Hostess deal, integrate those bakeries, and set about with efficiency improvement initiatives, I doubt the company is done with its aggressive expansion plans. Over time, I see little reason to believe that the company won't extend over the rest of the country, likely using focused regional deals to enter markets like the upper Midwest and Pacific Northwest. I also wonder if more expansion into packaged baked goods could be in the company's future. Relative to companies like Kellogg (NYSE:K), Campbell, and Mondelez (Nasdaq:MDLZ), Flowers is barely present in markets like crackers and this too could be a long-term growth and capacity leverage opportunity.SEE: Food Plays That Look Savory The Bottom LineAll told, Flowers has nearly 18% of the U.S. fresh bakery market between its brands and store brands, leaving it a distant second to Bimbo at about 33%. Likewise, the company's 12% share in cakes makes it a credible national player (Bimbo is at 14%), but one with room to grow. My only real hesitancy at this point is the valuation on the shares and the apparent slowdown in investor momentum in consumer stocks. A long-term revenue growth forecast of 7% and an 11% free cash flow growth forecast can get you into the low-to-mid $20s, a target supported by the company's ROE/PBV. I wouldn't rule out the possibility of the company beating those numbers, particularly if it can drive better efficiencies from Hostess, but I'm not sure there's quite enough margin of safety to make a big new commitment to these shares today. Disclosure: At the time of writing, the author did not own shares of any company mentioned in this article.

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