Steeper Prices Aren't Damping Consumer Demand for Narrow-Moat Hostess' Products

Senior Equity Analyst

Rebecca Scheuneman

In the past five years, Hostess averaged 6% organic sales growth, materially outpacing the 2%-3% growth of the sweet treats categories per Euromonitor. Market share gains were driven by compelling innovations, as Hostess has developed an effective innovation process due to significant investments in talent and tools over the last few years. Hostess mines consumer data to better understand the factors that drive snacking occasions, analyzes where current offerings are not meeting consumer needs, and develops products that specifically target these needs. Hostess has identified five snacking occasions it will focus on that represent a collective market of $50 billion (in relation to the $15 billion market that it currently operates in), with each occasion growing at a mid-single-digit pace. These occasions are morning sweet start, lunchbox, afternoon reward, immediate consumption, and afternoon sharing.

We believe the Hostess brand’s demonstrated pricing power, selling at a consistent premium to its branded competitors, provides evidence of an intangible asset. In addition, we believe Hostess is a valued partner in the convenience store channel (supporting another facet of the firm’s intangible edge), where the sweet baked goods category drives a material portion of channel revenue and Hostess is the market share leader. These competitive advantages lead to our narrow moat rating.

Hostess has created significant shareholder value via its disciplined acquisition strategy. Although the 2018 Cloverhill acquisition initially depressed margins, the business is now generating healthy profits, and the deal provided a breakfast platform and access to the club channel, where the firm is expanding the Hostess brand. We think the January 2020 Voortman Cookies acquisition also adds material value, as the business' expected 5% long-term sales growth does not dilute the firm's sales trajectory, margins are comparable with those of the highly profitable Hostess brand, and as the top-selling brand of sugar free cookies, provides a brand to leverage in the growing better-for-you snacking segment.

Business Strategy & Outlook

The Hostess brand has exhibited impressive staying power, despite changing consumer dietary preferences over the brand’s 100-year history, and as such, we award Hostess a narrow economic moat rating based on the firm’s brand intangible assets. Although the previous owners of the Hostess brand filed for bankruptcy in 2004 and 2012, we contend it was due not to a lack of brand equity but rather highly inefficient manufacturing and distribution systems, a powerful unionized workforce, and a high debt load. Furthermore, a lack of financial flexibility limited the company’s ability to respond to consumers’ changing desires, resulting in declining sales as low-carb diets and clean eating movements swept the nation. Changes to the company’s cost structure were insufficient during its initial reorganization, which led to the second trip to bankruptcy court. However, the current company is not the result of another reorganization but the creation of an entirely new company. After the 2012 bankruptcy, investors purchased only the brand rights and recipes from the bankruptcy court, freeing them of employee benefits and other labor obligations that had weighed down the company in the past. 

Despite a broad move toward healthy and clean eating, consumers seem to feel nostalgic about the Hostess brand, generating a public outcry at the firm’s 2012 bankruptcy with many reports of consumers stocking their freezers with the sweet treats in fear of no longer having access to them. However, we think the most impressive and relevant evidence of the brand’s enduring intangible asset value is its demonstrated pricing power, with the Hostess brand selling at a consistent premium to its branded competitors across all products. Hostess is the second-largest brand in the sweet baked goods category, and its products sell at a material premium to the number-one brand, Little Debbie. 

The significant price premiums have not deterred consumers. Hostess has steadily increased market share of the sweet baked goods category since its July 2013 relaunch, from 7.4% in 2013 to 21.3% in 2021, according to Nielsen. The top three brands account for 65% of the category, while the rest of the category is fairly fragmented. Private label is only 9% of the category, compared with 16%-17% for overall packaged food per Euromonitor, implying that consumers show a strong preference for trusted brands in this category. 

We believe that a second source of Hostess’ brand intangible asset advantage is its status as a valued partner in the convenience store channel. We think the cakes, pastries, and sweet pies category is a significant category for c-stores, ranking as the channel’s 10th-largest category per GlobalData. The morning goods category, which Hostess also plays in, is a top 20 category. Hostess is the number-one player in the sweet baked goods category in this channel, with 30% share in 2021, according to Nielsen. It is the largest channel for Hostess, representing over 40% of the firm’s point-of-sale retail sales, or about 30% of company sales (as c-store products have a higher average retail markup). Hostess works closely with its retail partners to optimize revenue in this highly impulsive category, in which merchandising can have a large impact on sell-through. In fact, management has said display merchandising is a more significant driver of sales than price for the category. We believe that Hostess supports its retail relationships with the significant amount of data it has amassed on consumer purchasing patterns for sweet baked goods, and we anticipate that it will continue to harness these insights to optimize category shelf space for its retail partners. 

Although the firm has opted to build out its mix through a handful of acquisitions to enhance its growth trajectory and diversify its category exposure, we continue to believe that its namesake brand is where its competitive edge is (which accounts for the vast majority of revenue and profits). In 2018, Hostess acquired Aryzta’s breakfast business, consisting of cinnamon rolls and Danish pastries sold under the brands Cloverhill and Big Texas, which have a strong presence in the value, vending, and club channels. This business also includes contracts to provide breakfast items for retailers to sell under their private-label brands. In 2020, Hostess acquired Voortman Cookies, the market leader in wafer cookies and sugar-free cookies. Despite these leading positions, the brand does not exhibit signs of strong equity, such as pricing power or even significant brand awareness. While these new offerings could further aid Hostess' sales prospects, we do not believe these additional businesses contribute to Hostess’ competitive advantage, given their smaller size and the fact that they have not demonstrated pricing power sufficient to imply the presence of a competitive advantage.

Further, we do not believe that Hostess has a scale-based cost advantage, even though profitability has improved as the new management team essentially built the company in its current form from scratch. It started by capitalizing on new extended shelf-life technology (which comes in the form of an enzyme provided by an ingredients partner) that increases shelf-life from 25-30 days to 60-65 days, enabling the firm to switch from the expensive direct-store-delivery model to the more cost-effective direct-to-warehouse model. Previously, the products had to be partially made in a central facility, then distributed to regional bakeries closer to the end customers to be baked and further distributed. With the new ESL technology, that is no longer necessary, and Hostess’ supply chain has been dramatically simplified (from 33 bakeries to 5, from 565 distribution centers to 3, from 18,500 employees to 1,350, and from an 80% unionized workforce to 30%). These improvements reduced transportation and distribution costs from 34% of revenue to less than 20%. In addition, the new company was launched with energy-efficient automated ovens and automated production lines. It simplified manufacturing by reducing the number of items it produces by 40% while improving capacity utilization from 50% to 80%. As a result, the firm’s manufacturing cost per case declined 17%. The financial impact of these changes has been significant, with operating margins for the old company averaging a low-single-digit loss while averaging a mid-20s profit for the new firm. We believe that Hostess’ direct-to-warehouse model provides certain cost advantages over its competitors’ direct-store-delivery models. However, as the DTW model as well as its automated and efficient ovens can be replicated, we do not consider it an enduring competitive advantage. In addition, Hostess does not have the same scale as its larger competitors: Flowers Foods (owner of the Tastykake brand), Grupo Bimbo (Entenmann's), and privately held McKee Foods (Little Debbie). In 2021, Hostess had $1 billion revenue in the U.S. and Canada to support its infrastructure in those regions, which pales in comparison to $4.4 billion for Flowers, $8.2 billion for Grupo Bimbo, and $2 billion for McKee, supporting our contention that it has failed to garner a cost-based edge. 

Hostess reports very healthy ROICs (including goodwill) of around 15% on average over the past three years, well above our 7% estimate of the firm’s cost of capital. We think this offers quantitative support for the presence of a competitive advantage. Further, we believe that it is poised to continue generating excess returns for the next decade.

Narrow

Economic Moat

Hostess Brands

Hostess Brands, Inc. engages in developing, manufacturing, marketing, selling and distributing baked goods. It operates through Snacking segment, which consists of sweet baked goods, cookies, bread and buns, and frozen retail products that are sold under the Hostess®, Dolly Madison®, Cloverhill®, Big Texas®, and Voortman® brands. The company was founded in 1919 and is headquartered in Lenexa, KS.

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Hostess Brands, Inc. engages in developing, manufacturing, marketing, selling, and distributing baked goods. It operates through the Snacking segment, which consists of sweet baked goods, cookies, bread and buns, and frozen retail products that are sold under the Hostess, Dolly Madison, Cloverhill, Big Texas, and Voortman brands. The company was founded in 1919 and is headquartered in Lenexa, KS.

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