Editor's Note: Last night, Hain Celestial (HAIN) announced the delay of the release of its fourth quarter and fiscal year financial results. The statement went on to say that the company had “identified concessions that were granted to certain distributors in the United States." It was "evaluating whether the revenue associated with those concessions was accounted for" and as such noted they would not meet their fiscal year 2016 guidance. The stock dropped -25% in after-hours trading.
Below is an institutional research note written by Hedgeye Consumer Staples analysts Howard Penney and Shayne Laidlaw published last October. Penney and Laidlaw have been the bears on HAIN for some time now and, in the note, they draw similarities between HAIN and the battered mess that is Valeant Pharmaceuticals (VRX). For more information about our institutional research contact firstname.lastname@example.org.
Hain Celestial (HAIN) is on the Hedgeye Consumer Staples Best Ideas list as a SHORT.
It might be a stretch to draw similarities between Valeant (VRX) and HAIN, but we see some very eerie similarities relative to their respective industries. The centerpiece of the SHORT call on both companies is focused on that fact that roll-up models carry big risks and rarely work over the long run.
Our Healthcare team used the following quote when they wrote the SHORT presentation on VRX last summer:
“That which has been is that which will be, and that which has been done is that which will be done. So there is nothing new under the sun.” -Ecclesiastes 1:9
The SHORT story was centered on Valeant operating an unsustainable business model of “serial acquisitions and underinvestment, fueled by debt that will continue to lead to deterioration in the ongoing business.” While the VRX story is just now coming to light and some smart money owns the name, there are now some very serious questions being asked about the company’s business model.
In our view, HAIN is essentially no different. HAIN is operating an unsustainable business model of serial acquisitions and underinvestment in its brands that will continue to lead to deterioration in the ongoing business. In addition, the recently acquired businesses carry lower margins and overall returns. One difference would be that HAIN’s balance sheet is not overly leveraged.
Like VRX trying to change the pharmaceutical business model, HAIN is trying to redefine how a typical food manufacturer operates a traditional business and that carries significant unquantifiable risks. These risks will ultimately lead to the company trading at a discounted multiple over time.
COMPANY GROWTH STRATEGIES
In the case of VRX, the company purchases innovation through serial acquisitions, exchanging R&D costs for interest payments and integration and restructuring costs (R&D spending at acquired companies is dramatically reduced). In the case of HAIN, HAIN purchases “new brands” through serial acquisitions; exchanging G&A costs for interest payments (higher share count) and integration / restructuring costs (G&A spending is nearly eliminated at acquired companies over 12 months following the acquisition.) HAIN further complicates its strategy by diversifying into new “organic” categories in which they are not part of the core competency of the company.
The short case for Valeant’s “new model” carries new and underappreciated risks. We now know what some of those unappreciated risks are for VRX. For HAIN, the street is just learning about some of the underappreciated risks. In our last note on HAIN, we outlined one of those risks that we see as being underappreciated by the market – outsourcing key brand related functions.
One of our biggest issues with HAIN is the secular decline in gross margins. As the environment for “better-for-you” products in the U.S. gets more competitive, HAIN will not be able to defend brands or market position. To that end HAIN, like VRX, does not invest much in R&D. In FY2015, HAIN incurred approximately $10.3 million in company-sponsored (less than 0.5% of sales) in R&D, up only from $10.0 million in 2014. Given how competitive this market is, spending 50% less on R&D than their competitors, is a long term issue for the company. In addition, HAIN like all other consumer staples companies does not report the spending incurred by co-packers and suppliers on R&D, which does benefit the company. That being said, outsourcing a critical function like R&D is an unquantifiable business risk.
As we see it, the only weapon the company has to defend itself from a secular decline in gross margins is to make massive cuts in G&A. Cutting G&A is never a long term winning proposition, and cutting too deep can put the long-term business model at risk. In 4Q15, it looks as if they are cutting into the muscle of the company. With the current G&A cuts announced for 2016, HAIN is now taking a big risk with their most important distribution channel.
In 4Q15, HAIN announced that they were moving their natural channel sales/merchandising team to Advantage Sales & Marketing to “drive SG&A productivity.” Advantage is a third party national sales and marketing company that works with many companies within the consumer packaged goods space.
This is just the latest move by HAIN to reduce costs, saving them roughly 20-25% per year. Advantage is used by some of the big players to supplement their sales and marketing in the natural & organic channel, specifically on slower moving sku’s. The problem with HAIN’s use of this company is its sole dependence on it, as they said they moved their entire natural channel merchandising team to Advantage.
Transferring the entire operation out of HAIN is strategically a very risky idea and could lead to a loss of brand expertise at the company. HAIN will effectively go from managing their brands first hand to having a third party manage them, depending on how their contract is structured (dedicated resources or not) will be a pivotal factor. The biggest advantage of an internal sales force is, share of mind, you want your employees pitching your products. How do you know the third party will be representing your brands in the best light?
These risks will only be known over time as selected brands begin to show slowing organic growth. Unfortunately, the street will never know that until it is too late, because the company lives in a culture of no bad news and does not disclose key metrics that allows investors to understand how the business is truly performing. Knowing they have something to hide, management has never consistently given the street historical context on:
- Organic sales growth by segment
- Non-organic sales growth by segment
- Volume growth by segment
- Price/mix by segment
- Shipment vs consumption timing
- Quarterly tone of business by region
Getting past the obvious similarities of roll up stories, HAIN is overvalued on its own merits. Nearly 40% of the operating profits of its UK business come from private label brands. In addition, most of the owned brands are not “organic” yet the company trades at a premium multiple relative to other mature food manufactures and/or private label business.