The Hain Celestial Group, Inc. (HAIN) produces, distributes, markets, and sells various natural and organic foods as well as personal care products with operations in North America, Europe and India. The company offers popular better for-you groceries (non-dairy beverages and frozen desserts, flour and baking mixes, cereals, condiments, cooking oils, infant and toddler food, etc.), snacks (potato and vegetable chips, organic tortilla style chips, whole grain chips and popcorn, etc.), and tea (include herb teas such as Lemon Zinger, Peppermint, Mandarin Orange Spice, Cinnamon Apple Spice, Red Zinger, etc.).
The Hain Celestial Group is the largest manufacturer in the natural foods segment and has several leading brands. Some of the prominent brands are Celestial Seasonings, Earth’s Best, Ella’s Kitchen, Terra, Garden of Eatin’, Sensible Portions, Health Valley, Arrowhead Mills, MaraNatha, SunSpire, DeBoles, Casbah, Rudi’s Organic Bakery, Hain Pure Foods, and Spectrum.
The company also provides natural personal care products under brands such as Avalon Organics, Alba Botanica, JASON, Live Clean and Queen Helene. The products of the company are principally sold to specialty and natural food distributors and are marketed nationwide to supermarkets, natural food stores, and other retail classes of trade including mass-market retailers, drug store chains, food service channels and club stores.
The company completely acquired Hain Pure Protein Corporation (HPP), which processes, markets and distributes antibiotic-free chicken and turkey products. The company also has a 50% stake in a joint venture, Hutchison Hain Organic Holdings Limited (“HHO”) with Chi-Med, a majority owned subsidiary of Hutchison Whampoa Limited.
Healthy Snack Foods
The Healthy Snack Food Production industry, which creates goods such as healthy chips, pretzels, roasted nuts, peanut butter, popcorn and other similar snacks, benefited from increased demand over the past five years. As the economy has continued to strengthen, discretionary income levels have climbed. In turn, renewed consumer spending has boosted sales of healthy chips, along with nuts and seeds. The price of key ingredients such as corn and wheat has also fallen for much of the period, reducing costs and expanding profit margins. Overall, industry revenue is anticipated to increase at an annualized rate of 5.8% over the next five years. This includes anticipated growth of 6.8% during 2016, bringing total revenue to $16.0 billion.
Shifting food consumption trends have affected the strategies of snack food producers. Specifically, growing health concerns about eating foods high in sodium, fat and sugar have made some consumers wary of consuming traditional snacks. Companies like Hain have entered the market with innovative products such as kale chips and roasted chickpeas. Demand for nuts and seeds have also grown as Americans have increasingly reached for trail mix and other healthy snacks. Additionally, as consumers demand more healthy versions of existing snacks, producers are expected to introduce a wider variety of products. The array of nontraditional ingredients currently used for snack production, such as taro root and butternut squash, indicates creativity will also be a key factor in future success. Hain has an extraordinary portfolio of brands that continue to innovate this industry.
Growing health awareness among Americans, coupled with new studies touting the healthful, antiaging benefits of tea, has bolstered industry demand considerably over the past decade. The tea industry is growing nearly twice as fast as coffee. According to the Tea Association of the USA, Americans drank over 80.0 billion servings of tea in 2015, representing a 10.0 billion serving increase from the 2014 figure. The overall industry is expected to grow at an annualized rate of 2.8% over the next five years.
Consumers are changing their dietary patterns to incorporate low-fat and low-sugar products, such as tea, as alternatives to staples like soft drinks and coffee. This dietary change is in response to the wave of publicity encouraging healthy eating and living habits; scientific findings and media reports are constantly reminding consumers to adopt healthier lifestyles. The increasing age of the population represents a potential for growth in the industry. While the aging baby boomers are usually not in the market for ready-to-drink iced teas (e.g. Arizona or Snapple), they are the main drivers of specialty teas like Hain produces.
In recent years, adverse health effects associated with red meat consumption have driven some consumers toward alternative protein sources. Among these sources are poultry and meat alternatives. New consumer trends have emerged around livestock feed and how those animals live their lives. Poultry and meat producers have responded by increasingly differentiating their products (e.g. grass-fed beef, free-range or caged chickens and organic products). The poultry and alternative meat industries are set to grow at an annualized 4.1% over the next five years.
Disease outbreaks are becoming social concerns which are pushing people towards organic meats. Concerns about the use of antibiotics and chemicals in meat production are leading some consumers to shift into new products. As customers move away from red meats, meat substitutes like seafood and eggs are also gaining market share.
The primary risk in this industry for Hain is around the cost of feed. Current forecasts expect poultry feed costs to rise over the next five years. These cost increases could be worse than forecasted if competition and demand for organic feed rises. However, Hain’s poultry and protein segments are positioned well in the marketplace to take advantage of social trends.
The cosmetic and beauty industry is a mature industry that will grow in line with US GDP growth. Hain’s primary focus in this market is in skin care products. Skin care is the largest product segment within this industry, accounting for an estimated 28.9% of total revenue. This part of the market has grown faster than the rest with anti-aging creams and other facial creams. This category includes facial creams and cleansers, functional products (products that serve a specific purpose, such as anti-acne or wrinkle-reducing agents) and men’s skin care products. Skin care products can command some of the highest price tags in the industry, with two ounces of some skin products selling for upwards of $200.00. A focus on antiaging treatments has boosted this segment’s visibility in the past five years. Companies looking to gain market share often invest in the creation of new products aimed at preserving a youthful appearance.
In the last five years, research has linked certain cosmetic ingredients to long-term health problems like cancer, which has led many consumers to shy away from traditional makeup. As a result, products featuring natural and organic components are increasingly gaining favor in the market. This will be a huge tailwind for Hain going forward.
Mergers & Acquisitions
Since its founding in 1993, the company has used acquisitions to drive growth. Revenues quadrupled from 1998 to 2000, when Hain and Celestial merged. Since the financial crisis, Hain has been on a buying spree. In the last five years, they have made 19 acquisitions that have expanded their product offerings into new markets. Hain has posted a 24% CAGR since 2010 and revenues are expected to be close to $3 billion this year. Irwin Simon, CEO and his team have done a terrific job with creating synergies and shareholder value. They have a superior knowledge base and understand consumers better than their competitors.
Greek God’s produces all natural, Greek-style yogurt, which is sold in natural and grocery retailers. Greek-style yogurt sales have grown over 400% in the last five years. I use a company like Chobani for the comp. Chobani has grown Greek-style yogurt sales from $78 million in 2009 to a projected $1 billion in 2016. Greek God’s had sales of $25 million in 2010. I expect them to reach $125 million or more this year. The Greek-style yogurt industry is expected to grow another 120% over the next five years.
Hain purchased Greek God’s in 2010. The terms of the deal were not disclosed. However, even if Hain paid 4x revenues, this has still be a terrific acquisition. The industry continues to grow and the move by Whole Foods to drop Chobani in 2013 has benefited Greek God’s. A conservative sales estimate of $125 million for 2016 and a 2x revenue multiple translates to a valuation of $250 million. As the Greek-style yogurt industry continues to grow, this brand could be worth $500 million in the next five years.
Ella’s Kitchen is a manufacturer and distributor of premium organic baby food under the Ella’s Kitchen brand and was the first company to offer baby food in convenient flexible pouches. They perform research that indicates sensorial interaction with food is the key to cultivating positive attitudes towards eating, which in turn can create healthy eating habits that will last a lifetime. The organic baby food industry has experienced dramatic growth in the last five years. It is expected to continue to grow as more research indicating potentially harmful effects of chemicals and pesticides on children. Organic baby food sales are expected to grow at an annualized 20% over the next five years.
Hain purchased Ella’s Kitchen in 2013 for an undisclosed amount. Ella’s generated $70 in sales in 2012. I expect Ella’s to make $110 million in sales this year.
Spectrum is a California-based manufacturer and marketer of natural and organic culinary oils, vinegars, condiments and butter substitutes under the Spectrum Naturals brand. They also sell essential fatty acid nutritional supplements under the Spectrum Essentials brand, sold mainly through natural food retailers. Spectrum is also a supplier of natural, organic and non-genetically-modified oils to food manufacturers in the United States through its Spectrum Ingredients Division.
Spectrum was purchased in 2006 for a mere $34.5 million. Spectrum is likely to reach $125 million in sales this year as their products are sold in broad array of retail stores. The company has expanded their product mix and entered new markets since the acquisition. The Spectrum brand is worth as much as $250 million today.
Revenue Recognition Issue
On August 15th, Hain Celestial filed a press release disclosing the Company had identified concessions made to certain distributors in the US that they would be reviewing. The review is around the timing of the revenue recognition. The Company is currently evaluating whether the revenue associated with these transactions were recorded in the correct period and is evaluating internal controls over financial reporting.
While I have not spoken to the company directly, I am fairly confident that the issues called out surrounding concessions and revenue recognition are minor in nature. The language used in the press release is challenging to understand at best. Based on what was disclosed, there are a couple of different accounting questions surrounding concessions/deductions and the pass-through of final discounts Hain makes to retailers. In the press release, Hain noted questions around whether revenue associated with distributor concessions was accounted for in the correct period, as historically, the company “recognized revenue pertaining to the sale of products to certain distributors at the time the products are shipped to such distributors.” My interpretation, although with no specific guidance from Hain, I believe this is related to sales to distributors that are eventually pushed to retailers with some form of growth rebate and/or charge-back accounting estimates.
ASC 605-10-25-1 is the revenue recognition standard that outlines the two factors that must occur for revenue to be recognized. 1) Must be realized or realizable. To be realized, products, must be exchanged for cash for the right to cash. 2) Being Earned. Revenue is not recognized until earned, revenues are considered to have been earned when the entity has substantially accomplished what it must do to be entitled to the benefits represented by the revenues. This standard is fairly straightforward. The wildcard is the concessions/deductions and pass-through of final discounts Hain makes to retailers. To be recognized, the amount of revenue must be determinable. In this circumstance, this would not occur until the distributor has sold the product to the retailer. Historically, the company “recognized revenue pertaining to the sale of products to certain distributors at the time the products are shipped to such distributors.” A screenshot of their revenue recognition practices from their 10-k is below.
In Hain’s 10-K filing, it notes sales incentives and promotions are used to support the sale of product but the expense recognition is estimated. While Hain noted these alterations are normally insignificant and generally in the same period, when factoring in two layers of selling the accounting treatment becomes difficult.
Financial Statement Impact
The Company has already indicated the amount of revenues will not change, only the timing of revenues. The change in timing will have some effect on margins. Assuming concessions make up 10% of revenues would imply a mere 1% revenue timing impact. I assume “concessions” refer to manufacturer charge-backs (MCB’s) deductions, growth rebates, and discount terms. There is a bit of a difference in the accounting treatment between rebates and manufacturer charge-back (MCB’s). For rebates, a company earns a “growth” rebate, earning extra bps of purchases for the year if they reach a growth target. If they are targeting 7% and they grow 2%, the customer doesn’t accrue rebate (works opposite way also). For charge-backs, Hain might say to a retailer “You earn X% off every case you sell”, If they estimate 60 cases and sell 100 cases, an accrual needs to be based on 100 cases now, and visa-versa. The ending charge-back is sometimes a waiting game which creates the timing issue. Assuming that 10% of Hain’s total revenue is associated with “concessions”, the timing issue should be small in nature.
Result of Review
I believe the outcome will be a revision to previous financial statements. This would be much better than a restatement of previous financial statements. I have reason to believe the probability of a material weakness in controls or a material misstatement in previous financials is remote. I think it is likely the concerns around revenue recognition are overblown.
Over the next three years, (FY17-FY19), Hain indicated it expects $100 million in global cost savings from its project Terra in addition to the $50 million in cost saving initiatives in FY16. Hain has retained Boston Consulting Group (BCG), and hired new COO Jim Meier’s to support the initiative.
Five Key Areas
Procurement & Logistics
Set up a procurement group in Lake Success with will oversee global purchasing and cost reduction. Will rebid freight lines and revisit transportation routing guides and contracts.
Identify low volume SKU’s to rationalize and replace with high-volume SKU’s. To date, Hain targets brands representing a total $30M in sales to package for divestment.
Optimizing Co-Packing Network
Reducing the number of co-packers, rebidding key categories and identifying joint purchasing opportunities with vendors and suppliers.
Reevaluating make versus buy across entire network or facilities
Reduce Spoilage & Discards
Reinvesting in systems, processes and reevaluating spoilage allowances.
With the anticipated savings from Project Terra, I believe Hain could return its US segment operating margins to FY15 levels (17.1%) with limited investment efforts. The cost savings are expected to be reinvested to generate growth in US brands. If Hain can achieve US segment operating margins in FY17 of 17.1%, then, even with no revenue growth, Hain would generate EPS of $2.13 (consensus $2.15). If they can achieve these margins and also hit their goal of mid-single digit revenue growth, I believe they can generate EPS of $2.20 or higher.
There are several risks to my thesis primarily because this is a competitive and growing market.
Retailers have added investments in natural/organic private label offerings. Food retailers across channels are slowly adding natural/organic private label products. Furthermore, many large CPG competitors are shifting strategic focus towards expanding their natural/organic food portfolio either through M&A or strategic shifts in brands. Either of these strategies could place potential market share pressure on Hain’s portfolio.
Change in Tastes
A slowdown in consumption of natural/organic foods caused by an economic slowdown, or consumer trends is a risk to the company. A change in consumer tastes away from healthy foods or another negative event resulting in a decrease in demand for natural foods.
Organic Food Supply
A tightening in organic food supply could cause sourcing issues. 95%+ of Hain’s portfolio is non-GMO. Both organic and non-GMO products have experienced supply tightness as demand has outpaced supply at times. While Hain has operated in this environment for over 20 years, unfavorable input prices and/or product shortages could impact Hain.
Hain has created material goodwill on its balance sheet from historical M&A activity. Unexpected impairment of goodwill would adversely affect the price of the stock.
The Company is trading near 52-week lows today at about $35. The stock traded down to where it is today back in January before running to $55. Due to the Company delaying its earnings announcement, it has made a round trip. As I have mentioned previously, I am not relying heavily on forecasts or valuations. My forecasts are biased and therefore, often wrong. The biggest advantage I have is understanding a particular business better than most and focusing on pieces of information being overlooked by the market. I have looked at Hain several different ways.
The Company has a fiscal year end of June so they are well into FY17. My income statement estimates are shown below. Results from Project Terra begin to show up in FY18 as margins begin to widen. From a financial perspective, the company was operating better in FY14 than today. Notice how they have cut SG&A to keep income margins 7-7.5%. However, current initiatives from the company will boost margins.
Using the inputs above we get to the valuations in the chart below.
In a normal growth valuation, a 9% growth rate was used. This is significantly slower growth than the 24% CAGR the company has posted since 2010. Project Terra will allow the Company to operate more efficiently and most importantly cut down on SKU’s. The median value of the stock is about $45. This represents about 29% upside.
Sum of the parts
A sum of the parts valuation indicates the stock is worth about $55. This represents about 55% upside. The sum of the parts story is tough considering this would be an M&A price. Today, the company might have too many SKU’s for a Craft Heinz or a Mondelez to be interested. However, if Project Terra cuts SKU’s, Hain will become more attractive. As the Company executes Project Terra, it may find groups of brands that would be attractive to a General Mills or Craft.
The Company should be wrapping up their accounting review soon and will release delayed earnings. I believe the probability of a material weakness in controls or a material misstatement in previous financials is remote. I anticipate a revision to previous financials. I think it is likely the concerns around revenue recognition are overblown. Once the accounting review clears, investors will once again focus on the business. I have bought some HAIN near $35.