Saturday, June 1, 2013

Is Treehouse Foods Still Good Value?

It has been a difficult couple of years for Treehouse Foods, and the share price is only above what it was back then thanks to the recent strong run. I’m sure that part of this is due to the market’s infatuation with the food sector this year (sparked by Buffett’s move into Heinz), but it is also down to the company successfully reorganizing its activities in line with market shifts.

With some successful acquisitions contributing to revenue growth in the quarter, and more M&A activity to come, its prospects are looking brighter than they have for a while. Is now the time to pick up the stock?

Food for thought

The recent results need to be looked at in depth to ascertain the underlying conditions. On the one hand, revenue was only up 3.1%, and this was largely due to acquisitions. On the other, adjusted EPS rose 17%, and restructuring activities have created a more favorable product mix. Production efficiencies, moderating commodity expenses, and supply chain improvements (transport efficiencies) have helped operating margins.

In a sense, these restructuring efforts were essential because the company has been faced with some difficult conditions in the last few years. Theoretically, a slow consumer environment where trading is down, and promotions and discounting are the key buzzwords, should be ideal for a private label manufacturer like Treehouse.

Unfortunately, it is not that simple. Shifts in consumer spending patterns, and more importantly where they buy certain groceries, has resulted in changing outlooks for some of Treehouse’s customers. Consequently, it has needed to restructure in order to realign its retail channels accordingly. The good news is that some of these changes are now coming to fruition.

There was a $0.14 restructuring charge relating to its soup operations, and if soup is excluded from revenue, then it would have risen a more respectable 7%. The strength comes from growth in its hot beverages (particularly single serve coffee) and from acquisitions in areas like refrigerated dressings and sauces. These are measures initiated to restructure, following some below par performances, with categories like soup and pickles, over the last few years. In addition, the management was pretty clear that more M&A activity is on the cards for 2013.

What to expect this year

Potential investors in Treehouse will have to accept that its prospects are somewhat dependent on the dynamics of the food industry. The industry story of 2013 is likely to be an environment of modest volume growth, aided by moderating commodity input costs. The question is, what will the food companies and grocers do in response? Will they try to hold pricing and take margins, or will they use the opportunity to lower prices and grab volumes or market share?

We got an early taste of these kinds of dynamics with ConAgra’s latest results. Its strategy seems to be to increase marketing activities in the face of weakening volume growth. Of course, this decision is guided by the fact that it tends to have value brands and is already competitive on price. In addition, its acquisition of Ralcorp is a positive indicator for private label manufacturers like ConAgra. In fact, across the retail market, the drive toward private label in-store brands has been a key development in the last few years. ConAgra has a lot on its plate this year, with integrating Ralcorp and dealing with some difficult conditions in the service food industry. Its evaluation of nearly 30 times earnings also suggests there is little room for error in its execution.

Meanwhile, grocers like Kroger have been rolling out corporate brands in order to better compete with lower-priced stores that have been gaining market share. In looking at Kroger’s earnings, I was struck by how tonnage came back strongly when prices abated. This is a sure sign that price sensitivity is still the key determinant of volume growth. The good news for Kroger investors is that margin pressure is finally starting to ease. Commodity prices are moderating for Kroger, and given its sterling efforts to retain market share and footfall with a mix of innovation and pricing, it should now see some margin growth.

A look at Kroger's revenue and margin trends:




Putting these thoughts together, I think it is clear that 2013 will be another year of intense competition categorized by promotions and discounts. As a consequence, the shift to private label brands is unlikely to slow down, and conditions should remain favorable for Treehouse. We are not yet in an environment where customers will take pricing easily.

Where next for Treehouse?

Full year EPS guidance of $3.00-3.10 was maintained, and conditions for Treehouse look better than they have for a few years. The restructuring activities are working, and moderating commodity costs should allow for volume increases, while the trend toward private labels continues. The company appears to have sorted out its retail channel challenges.

The bad news is that, on a forward evaluation of 21 times earnings, the stock is hardly cheap, and I would argue that this sort of company usually needs to be priced at a relative discount to reflect the risk inherent in buying a company whose prospects are largely governed by its customers' trading patterns and decisions.

If you are looking for relative value (in an expensive sector), Treehouse may fit the bill. But, cautious investors may want to wait for a better entry point.