Sometimes the market falls in love with companies that offer premium-priced goods, and other times the fancies of institutional investors turn toward the world of discount retailers like Wal-mart Stores (NYSE: WMT) and Family Dollar Stores (NYSE:FDO) and the manufacturers or private label products like TreeHouse Foods (NYSE:THS). With high unemployment and nervous consumers dominating the story in retail, bargains are back in vogue. Although TreeHouse is a good company in a market ripe for further consolidation, investors should hold back and wait for a sale on these shares.
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A Quality Problem For Q3
Although TreeHouse met its numbers for the third quarter, how the company did so is an issue. Revenue rose about 14% from last year, but growth was boosted in a big way by acquisitions. The company's largest segment, North American retail grocery, saw almost 16% growth on a reported basis, but just 5% growth ex-acquisitions, and unit volume growth was just 1%.
On the profit side of things, gross margin did tick up nicely on a sequential basis (up 160 basis points), but just 3 basis points compare to same quarter last year. Likewise, operating income rose 10% and the company saw slight erosion in the operating margin. All in all, were it not for some forex benefits and a favorable tax rate, TreeHouse wouldn't have met its numbers. (For additional reading, check out: A Look At Corporate Profit Margins.)
Pricing and the Devil in the Details
TreeHouse seems to have recovered from a slip-up earlier in the year where management lagged in raising prices to account for higher input costs. To be fair, this is a tricky business. Larger branded food companies like General Mills (NYSE:GIS), Kellogg (NYSE:K) and Kraft Foods (NYSE:KFT) have all had their own challenges in the timing and magnitude of price hikes and balancing that out with on-the-shelf volume losses.
Arguably that's an even harder balance for a company in TreeHouse's position. Major customers like Walmart can't switch private label vendors overnight just because of aggressive price hikes, but there is no doubt that there is a delicate balance here. Walmart is a fierce customer and if TreeHouse pushes too far, Walmart will eventually go elsewhere.
Plenty of Share to Gain
TreeHouse has certainly caused enough headaches already for branded competitors like Campbell Soup (NYSE:CPB) and General Mills in soups, and Kraft and Clorox (NYSE:CLX) in salad dressings. And yet, there's still plenty of room for the company to grow and plenty of other opportunities to take share from branded names - including companies like JM Smucker (NYSE:SJM) in jams and coffee.
More to the point, TreeHouse can likely still pursue a two-pronged growth strategy. Management has indicated that just a moderate amount of capital expenditure (capex) would allow them to move into the "K cup" market in coffee, and other internal/organic growth opportunities exist beyond that. At the same time, the private label market is still fragmented and ripe for consolidation. While TreeHouse has a debt-heavy balance sheet and ConAgra Foods (NYSE:CAG) seems keen to buy into this market, even relatively small acquisitions could boost performance.
The Bottom Line
Unfortunately, TreeHouse's story is well-known and well-appreciated. In a market where names like Unilever (NYSE:UL) and General Mills are slightly undervalued and Kraft and Kellogg are slightly cheaper still, TreeHouse pops out as arguably overpriced relative to its growth and cash flow prospects. This would be a fine company at a better price, but until TreeHouse shares go on sale again, investors would be better served sticking with the branded names. (For additional reading, check out: The Value Investor's Handbook.)
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At the time of writing, Stephen Simpson did now own shares in any of the companies mentioned in this article.