Flowers Foods (FLO) is on the Hedgeye Consumer Staples Best Ideas list as a SHORT.

 

HEDGEYE OPINION

Slow business fundamentals, increasing lawsuit costs, and a looming DOL investigation are all headwinds currently facing FLO, and relief is nowhere in sight. As we expressed in our Sneak Peek note earlier this week (CLICK HERE), an increasingly competitive environment and slowing consumer demand have continued to take a toll on the business, and management has struggled to find a way to strengthen the brand through this difficult environment. They have committed to increase their own promotional activity to better compete and regain market share. Outside of bread, their cake business is being increasingly threatened by Hostess, and this pressure will not abate easily.

The company announced that it had settled one of its 23 lawsuits this quarter for a surprisingly low $1.25M.  We suspect that the company needed a “win” to shift the conversation away from a potentially catastrophic scenario.  Still, there is nothing in this announcement that changes our opinion of the potential issues the company faces.      

The lone bit of tangible progress seen this quarter was the company’s completion of the first phase of Project Centennial, which included a comprehensive diagnostic evaluation of opportunities to reduce costs, drive growth, and strengthen the brand’s competitive position (Phase two of the project began in mid-October). Management has yet to quantify the savings but did enlighten us on some buckets they are focusing on; reducing indirect costs, network optimization and the potential for SKU rationalization are top of mind. Management also spoke to wanting to reinvest and drop some to the bottom line. Given that FLO is already a pretty lean structure, we feel that dividing the cash amongst too many buckets could limit its positive effects, but that remains to be seen.

However optimistic they are about Project Centennial, the legal headwinds seem to have stumped management, as they have no idea of possible effects going forward and were unable to provide listeners with any details on how litigation will affect the business in the near future.

The company missed on all major categories, reporting Direct-Store sales of $768.9M vs Consensus $769.1M, with volume down -2.1%. Sales from warehouse operations came in at $149.8M vs Consensus $151.7M and adjusted operating income was $67.5M vs Consensus $71.6M.

We continue to stay firmly SHORT FLO in our Position Monitor.

 

NOTABLE COMPANY THOUGHTS

“While we are pleased with the performance of Dave's Killer Bread, which continues to gain share as America's #1 organic bread brand, our results in the third quarter were affected by challenging category dynamics and elevated marketing and legal costs,” (Allen L. Shiver, CEO)

HEDGEYE DKB is a distraction and will never be a reason to buy the stock.   

“If you look at legal costs year over year, I’d say obviously they’re up fairly significantly. It’s hard to project how they turn out as we continue with the litigation that’s before us, so to sit here today and try to say if they’re more elevated than they will be in the future or I mean that’s hard to predict. All I can say is they are elevated compared to the prior year…We continue to monitor each case and at this point not taking any further reserves in terms of what we committed for the Connecticut case. We do continue to monitor each situation and will act accordingly when we think it’s best.”

HEDGEYE – Management is unable to provide any significant information regarding future legal costs, or what to expect from any pending settlements. This does not bode well for future profitability.

“Generally, when you look at our internal expectation, I’d say we continue to see downward pressure on our core business and that’s the primary driver of where we want to perform better. We think we should be performing better, we just continue to see overall pressure on our core brands. We’re very pleased with our non-retail and warehouse segments, and cake has been slightly down with the brand as well.”

HEDGEYE As we touched on earlier, the core business is taking the biggest hit and management is hard-pressed to find a solution that will create meaningful growth for that part of their business.

In response to a question about how much commodity inflation to expect: “Obviously we haven’t given guidance for 2017, but as you look at it overall, in 2016 there was a nice tailwind; commodities and all input cost seems to have stabilized somewhat now as we progress through the year. So as we move into 2017, while we expect some important benefits, we’re not expecting tremendous tailwinds like we saw in 2016,” (Allen L. Shiver, CEO)

HEDGEYE Management expecting commodity prices to normalize and this could hurt the business if things continue the way they have. 

 

QUICK COMPS

EPS: $0.21 ex-items vs FactSet $0.21

Revenue: $918.8M vs FactSet $920.5M

Adjusted EBITDA $101.7M vs FactSet $104.8M

Net Sales:

  • Direct-store: $768.9M vs Consensus $769.1M
    • Volume (2.1%)
    • Price/mix +1.1%
  • Warehouse $149.8M vs Consensus $151.7M
    • Volume +2.8%
    • Price/mix (1.3%)
  • Adjusted Operating Income $67.5M vs Consensus $71.6M
    • Direct-store $66.3M vs Consensus $69.3M
    • Warehouse $12.3M vs Consensus $12.9M
  • Adjusted operating margin 7.3% vs Consensus 7.8%

OUTLOOK

Although management reaffirmed their guidance range, they noted that they were trending towards the low end of the range across all metrics and remain cautious going forward. Looking to 4Q and 2017, FLO will be faced with a higher level of legal expenses, increased marketing expenses to strengthen core brands and grow DKB, as well as a lesser or non-existent benefit from input costs, which was a strong tailwind 2016.

  • Company reaffirms EPS $0.90 – $0.95 vs FactSet $0.91
  • Revenue $3.930B vs $3.986B vs FactSet $3.93B
  • EPS Guidance: $0.88

Please call or e-mail with any questions.

Howard Penney

Managing Director

Shayne Laidlaw

Analyst