TreeHouse Foods Falls Back To Earth

By Stephen D. Simpson, CFA | November 06, 2012 AAA

TreeHouse Foods (NYSE:THS) is a case in point as to why I try very hard to stick to my guns when the stock of a good company looks too pricey. While TreeHouse has been one of the more dynamic companies in the private label food space (and one of the relatively few investment plays on the space), valuation left no room for error on performance and recent results have started showing some error. Although I still don't believe these shares are especially cheap, it would be a name I'd revisit if the stock continues to slide.

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A Big Miss For Third Quarter
TreeHouse posted a sizable miss for the quarter, coming in short at the top and bottom lines. While the reported EPS miss was about $0.08 relative to the average sell-side target, a better-than-expected tax rate boosted bottom-line results by about $0.04.

Revenue rose about 2% as reported, though organic growth was actually down 2%. The large North American Retail Grocery business saw 4% growth in reported revenue and about 2% growth in organic revenue, with a 2.5% price/mix improvement offset by a 0.6% decline in volume. In the Food Away From Home segment, reported sales rose 13% but organic revenue dropped about 1% on a nearly 5% decline in volume. Industrial and Export was even weaker, with revenue down almost 20%, but the year-ago comp (up 28%) was especially challenging.

Profitability was an even bigger challenge for TreeHouse. Gross margin was hit by input costs and volume de-leverage, and gross margin fell close to three points on an annual comparison, though it did improve almost a point sequentially. Operating income (adjusted) fell about 14%, leading to an almost two-point contraction in operating margin. All of the company's segments saw operating income declines, with mid-single digit declines in retail grocery and Food Away and a high-teens decline in Industrial/Export.

SEE: Analyzing Operating Margins

Was It Timing, or Something More?
Bulls wishing to defend TreeHouse may find some solace in timing issues regarding shipping in the retail grocery business. The downside for private label companies such as TreeHouse and Ralcorp (NYSE:RAH) is that grocery companies such as Kroger (NYSE:KR) and Walmart (NYSE:WMT) don't always work closely with them to smooth out ordering patterns, and shipment demands can vary with little warning. TreeHouse did see a sizable drop in volume toward the end of the quarter, but apparently volumes have already improved in October.

On the other hand, branded food companies have been getting more active and aggressive with promotions. So maybe more aggressive moves from companies such as Unilever (NYSE:UL) or Clorox (NYSE:CLX) are behind the lower volumes in dressings, and likewise perhaps Campbell Soup (NYSE:CPB) and General Mills (NYSE:GIS) are pushing harder in the soup category.

It's also worth asking whether TreeHouse needs to take a page out of United Natural Foods (Nasdaq:UNFI) and start rationalizing costs. I realize these are very, very different businesses (UNFI is an organic foods wholesaler/distributor), but the point stands that I think TreeHouse may have too many uneconomical accounts and may need to rationalize its client base to operate more efficiently. At the same time, while management believes the M&A environment is improving (and the private label food business is ripe for consolidation), management needs to balance sales opportunities with the right amount of manufacturing capacity.

SEE: Industry Handbook: Porter's 5 Forces Analysis

The Bottom Line
I do like TreeHouse, and I understand why investors are attracted to this pure play on private label food. Not only are there ample acquisition opportunities out there, but I also think the company can be a player in single-serving coffee (private label K-cups). At the same time, the company's organic operating income growth hasn't been that great over recent years, and valuations did reach pretty excessive levels in my view.

I'm not cutting my expected growth rates as much as many sell-side analysts have done, as I believe there's too much of a tendency to overcorrect after bad (or good) quarters. I do believe that TreeHouse can outgrow the average food company on the sales line and post much better free cash flow margins as well, leading to a low-teens forward free cash flow growth rate. Unfortunately, that's still not enough - even if you exclude/ignore the company's high debt load, the shares' fair value still only appears to fall in the low $50s and they don't seem to offer much potential at today's price.

At the time of writing, Stephen D. Simpson did not own any shares in any company mentioned in this article.

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