I used to be an enthusiastic shareholder of Hain Celestial (NASDAQ:HAIN), a leading provider of natural and organic goods. With the grocery business being rapidly commoditized, I reasoned, Hain stood at the sweet spot of getting to sell to anyone who entered the fledgling niche.
Over time, however, I began to realize a troubling pattern: not only were grocers being commoditized, so, too, were those providing organic, natural, and better-for-you goods. That's why I sold all my shares long before the just-resolved accounting scandal broke.
While I think the company's year-long hiatus from reporting earnings due to accounting issues is a troubling sign from an institutional standpoint, I think it's largely noise that is distracting investors from the biggest concern: continuing commodization of the company's brands.
Wishing for a wider moat
In the company's most recent conference call, analysts were eager to ask CEO and founder Irwin Simon about his plans to grow the company, especially in the face of the recent acquisition of Whole Foods (NASDAQ:WFM) by Amazon (NASDAQ:AMZN).
Scott Mushkin of Wolfe Research pointed out that Hain hygiene products that sell for $14.99 at Whole Foods go for just $10.99 on Amazon. That difference likely represents the bulk of Hain's margin. Simon responded by saying:
I think what's important is I'd rather be selling a lower margin product with 5% growth than a higher margin product with negative growth.
That's a fair sentiment to have...as long as you believe that your products are the ones that new consumers of natural and organic products are going to be buying.
The thing is, I believe that the last few years have shown that such shoppers are much more loyal to the low-cost leader than to brand, so long as the product crosses the hurdle of being "all-natural", "organic", or "GMO-free."
Indeed, that's the very same point that John Baumgartner of Wells Fargo made later in the conference call, asking how the company would compete with private labels like Whole Foods' 365 brand.
Brand equity, brand equity, and when my twin boys were born, I wanted to call one brand and one equity. So that's how much I believe in brands versus private label...And I'm a big believer [that] millennials and consumers will buy brand.
Again, that's a fair sentiment to have, but what really matters is how this plays out in the real world. Sad to say, Hain's gross margins -- a key indicator of the strength of the company's brand and pricing power -- have been headed in the wrong direction for years.
Remember, none of this is affected by the costs of the accounting snafu, or any goodwill writedowns that the company has had to take. It's simply a measure of how many cents on each dollar of sales the company keeps before taking out other related costs.
With the greatest threat being commoditization, with evidence of that process having already appeared, a CEO who seems to be ignoring this fundamental problem, and the world's most customer-centric and low-price leader (Amazon) entering the fray, I don't want anything to do with this stock.
But I wouldn't short it either
There was, however, one very strong and -- for me -- surprising part of Hain's delayed earnings release: very strong free cash flow. When the company last reported in mid-2016, it had trailing free cash flows of $16.2 million.
Fast-forward to today, and that number has jumped all the way to $159.4 million.
Granted, much of this growth has come not because the company's operations are spewing out that much more cash, but because the business has hit the breaks on its capital expenditures and growth-via-acquisition strategy.
That being said, the stock now trades for 22 times free cash flow, and under 20 times the mid-point of free cash flow that management expects to pull in during the 2018 fiscal year ($182 million). That makes it a viable takeover candidate, and no investor wants to get caught on the short side of that kind of deal.
That's why I think the best thing investors can do is stay away. If someone swoops in to buy Hain, you'll kick yourself for shorting it. But if no one else does, I think there's a good chance you'll be holding a business that's rapidly commoditized.