Hain Celestial (HAIN) fell 25% on August 16, after acknowledging that the company was stuffing the channel and that the annual filing would be delayed.
I think this event is another symptom of an unhealthy company and don’t think that the stock sell off eliminates the short opportunity. Going into this announcement, the stock was very strong on takeout rumors, particularly on the heels of the WhiteWave buyout, and general consumer staples healthy valuations. Plus, HAIN cancelled its appearance at the Jefferies consumer conference in mid-June and didn’t announce the date of its earnings announcement, which typically is during the second-to-last-week in August. The market speculated that these events were the backdrop of M&A and bid the stock up, including 7% on Friday, August 12. I believe a lot of the stock reversal was the unwinding of these views, that the longer-term fundamental short thesis is still available, and that the stock is worth $30.
HAIN is on the back-side of a struggling roll-up strategy, facing intense competition, with poor quality of earnings, focusing on maximizing near-term “adjusted earnings” at the expense of long-term “economic earnings”. The key is that HAIN buys product lines – they’ve done over 50 acquisitions since 2010 - and does not invest (via advertising) to support growth. For a mental framework – think Valeant – a serial acquirer, with little R&D (advertising), that gets to exclude a bunch of “1x” items to come up with a Non-GAAP figure that folks should believe will eventually be sustainable. But all those investment cuts eventually result in shrinking sales.
HAIN argues that its recent stumbles are a result of poor performing products and that the solution to fixing its problem is to cull its product portfolio – focusing on the better selling items. This strategy is supported by their consultant, Boston Consulting Group, who advised them on this magic fix. But, I think these recent results are evidence of the competition that is challenging their high margins, left unprotected from their approach of limited marketing efforts.
The bull-case is that HAIN operates in a fast-growing segment (organic products) and that a larger consumer products company will acquire it. It’s a simple thought and it’s easy to swallow, but a more detailed analysis shows an unhealthy business that still has a rich stock valuation.
Hain Celestial (HAIN) is a manufacturer, marketer, and seller of products focused on branded natural and organic items. There are 60+ brands but none of them are overly popular or have significant market share in their categories. Its average sales per brand are just ~$35m which is significantly lower than competitors such as Whitewave which has $400m, Annies at $200m, or Diamond Foods at $175m. Some of the best known brands are: Earth’s Best, Celestial Tea, and Terra Chips. Products are sold primarily to retailers and distributors in US and UK and the company has completed more than 50 acquisitions since its founding in 1993 by Chairman & CEO Irwin Simon. The company was an early entrant into the organic space, but is now facing competitive pressure from larger consumer product companies, private label, and other new entrants. 60% of its products are internally manufactured and 40% are co-packed.
Competition and Poor Competitive Position:
Large consumer products companies can out-market and promote HAIN because of their more efficient cost structure, stronger financial structure, and better brand portfolio. From the other side, private label companies (Whole Foods 365, Wal-Mart Wild Oats, Kroger Simple Truths or Stop & Shop Natures Promise) can compete better on price and take share. That leaves HAIN stuck in the middle – fighting to keep what it enjoyed as a first mover, while trying to persuade shareholders that their current fat profits are sustainable, and likely trying to get bailed out through an acquisition. But, unfortunately, they are in a tough spot.
“We appear to be at an inflection point in the natural and organic category with, among other things, more competition than ever before, be it traditional, natural and organic competitors or deep-pocketed conventional CPG-backed competitors, private label or startups…” - John Carroll: EVP & CEO Hain Celestial North America (Feb. 2, 2016)
That’s the big picture and the following are symptoms of the difficult position I believe the company and stock is in.
Weak Organic Growth in US – the US organic products market is growing close to 10% per year. But, HAIN’s US organic sales declined ~4% y/y in the September and December 2016 quarters, before rebounding to +3% in the March 2016 quarter. Given the recent admission that they were inaccurately recognizing revenue, it likely would have been even worse. HAIN argues (and Boston Consulting Group concluded) that this weakness was because of HAIN’s poor-performing products. I argue that it’s because they are in a difficult competitive position and haven’t invested in their brands to maximize short-term profits.
Not Investing by Advertising – HAIN spends less than 1% on advertising, compared with an average of 5-6% at peers (HSY, K, WWAV, SJM, MDLZ, GIS, and CPB). For HAIN to maintain its market share, I think they need to invest in advertising at a similar level with of its peers, which would lower their US operating margins to 11% from 16% currently.
Accounting Errors and Filing Delay – on August 15, HAIN announced that it was delaying its 10K filing because of improper revenue recognition. In other words, they were stuffing the channel to make the current numbers look better.
Executives Leaving Company – these guys made the right moves: the CFO, Steve Smith, was fired in September 2015 and the Chief Accounting Officer, Ross Weiner, resigned in February 2016.
Recurring Non-Recurring Adjustments – over the past few years, adjustments have averaged ~20% of adjusted net income. Even worse, there they seem to have recurring adjustments to their non-recurring items, such as the NutButter Recall in 2014. In the 2014 10K, the company stated: “On August 19, 2014, the Company announced a voluntary recall…the Company recorded costs totaling $6m in [FY14]…While the cost of the voluntary recall to be recorded in fiscal 2015 is not yet known, it is reasonably possible that the total pre-tax costs of the recall related to fiscal 2015 may be between $4-8m.” Total charges in FY2015 for the nut butter recall were $34m.
Wandering Acquisition Strategy – since 2010, HAIN has been increasingly reliant on acquisitions outside of the US where they have less (or no) distribution synergies. If you look at the implied return on invested capital from their UK acquisitions, I estimate it’s been less than 5% (over the last 12 months, their UK segment has produced operating profit of $66m and if you allocate corporate expense and adjust for taxes, NOPAT is ~$40m). They also purchased Hain Pure Protein – an organic chicken business - in 2014. This also is a lower margin, more commoditized business. And, Pilgrim’s Pride has announced they are adding capacity with the intent of capturing 20% market share over the next few years.
Insider Sales – until 2015, insiders were consistent sellers of the stock and the CEO shed nearly $50m of holdings from 2011 – 2015. He currently owns 1.8% of the shares outstanding – pretty low for the founder of a company.
Celestial Tea Excuse in March 2016 Quarter – in the March 2016 quarter, the company blamed its margin pressure completely on its Celestial tea business. But the numbers don’t add up: Celestial Tea does ~$120m in sales. The US segment margin decline was 1.4%, which would imply margins at the Tea business falling by 16%, but I doubt the drop was that large. I suspect margins fell in their other segments as well, but HAIN wants to keep the focus away from any problems with its organic products since that’s where the hype is.
EPS and Valuation
The current guidance for FY2016 (Ending June) is for ~$2.00 v. $1.88 the prior year. The $2.00 includes $0.20 of adjustments. First, let’s say that half of the adjustments are part of the normal course of business and that there isn’t a major restatement to EPS from stuffing the channel. That’s $1.90. But, because they don’t spend on advertising, I believe this profit is overstated (or their top-line will shrink because of it).
If HAIN increased marketing expense to 5% of sales in the US (in-line with competition), EPS would be ~$1.45. From this level, I would accept the argument that HAIN could grow with the industry at high-single-digits and believe the market would put a 20x multiple on those earnings, or $29 per share.
More importantly, for the short, I think the stock continues to be weak as shareholders adjust to the reality that this isn’t a great company and that no large consumer products company will bail them out.
Takeout Risk - I’d be more worried if this company had a few strong brands/products that a larger company could weave into its distribution or marketing efforts. But, HAIN is a collection of sub-par brands that have been weakening.
Trading: I'd have a position here and be more aggressive shorting in the high $30's, low $40's.
I do not hold a position with the issuer such as employment, directorship, or consultancy. I and/or others I advise hold a material investment in the issuer's securities.
Continued earnings pressure
Realization that while total revenues may not be restated from their recent accounting issues, they did pull forward a meaningful level of sales.