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This Just In: Hostess Brands Stock Upgraded

By Rich Smith – Jun 24, 2019 at 2:43PM

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UBS thinks there's "25% upside" in store for investors.

Every day, Wall Street analysts upgrade some stocks, downgrade others, and "initiate coverage" on a few more. But do these analysts even know what they're talking about? Today, we're taking one high-profile Wall Street pick and putting it under the microscope...

Nearly seven years ago, Twinkie maker Hostess Brands (TWNK -2.60%) filed for bankruptcy.

Four years later, Hostess returned to the public markets -- and within a year, was worth more than Sears!

And one analyst believes it's just getting started.

Plate of Twinkies

Image source: Getty Images.

Hostess today

When last we heard from Hostess Brands (in May), things were not going great for the junk food specialist. Q1 2019 sales were up 7% year over year, but per-share profits were down a whopping 11%. In part because of this, Hostess stock's momentum has been halted, and the shares are actually trading down a bit over the last 12 months (while the rest of the S&P 500 is trading up).

And yet, Hostess management reported last month that it was "seeing positive trends in both merchandising and consumer support headed into Q2." Executives remained confident in its ability "to achieve our annual outlook," predicting revenue growth "well above the sweet baked goods category," "adjusted" earnings per share of $0.57 to $0.62, and free cash flow in the neighborhood of $125 million.

Hostess tomorrow

In part because of this forecast, this morning analysts at Swiss investment bank UBS announced they are upgrading shares of Hostess to buy, with a $17 price target implying about "25% upside."

"[P]er Nielsen data," says UBS, "Hostess sales trends are accelerating ... as it launches new breakfast product lines & regains shelf space at its largest customer," Walmart. Additionally, the company's recent acquisition of "a Chicago Bakery facility, which had been poorly operated under prior ownership, brings Hostess new production capability in breakfast categories."

With sales growing and production capacity to support those sales growing as well, UBS argues that Hostess is now "on pace to generate $350 [million]-400 [million] in FCF over three years," generating cash that the analyst believes the company will use to pay down its debt, resulting in a "$2/share" increase its enterprise value.

(Enterprise value, being a function of market capitalization, cash, and debt, rises when debt disappears.)

Crunching the numbers

This is an optimistic forecast for Hostess to be sure. But do the numbers add up?

On the free cash flow front, at least, they do. Data from S&P Global Market Intelligence show that the consensus of the 10 analysts currently following Hostess stock is that, from 2019 through 2021, total free cash flow at the company will in fact approximate $400 million. Free cash flow from 2020 through 2022 is expected to add up to $435 million, so depending on the exact time period UBS is discussing here, the analyst's projections of Hostess' cash profit could even be a bit conservative.

I'm a little more worried about the sales growth expected to support this growth in free cash flow, however. For example, forecasts for 2019 show that most analysts only see Hostess growing its sales by about 5% over 2019 levels, to $894 million. Moreover, growth is expected to slow to just 3% in 2020, and 2% in 2021 and 2022.

What it means for investors

Granted, Hostess has been doing a bit better than that lately. In the final three quarters of last year, for example, the company grew its sales 6%, 10%, and 10%, respectively. But Q1's 6.7% sales growth result does seem to support the consensus forecast that things may be starting to slow down for Hostess -- albeit only slightly, and albeit only for one quarter (so far).

Still, if sales growth does end up slowing as abruptly as most analysts predict, this would not be good news for Hostess...or its prospects of generating $400 million in cash over the next three years...or its ability to use that cash to pay down its nearly $1 billion in debt, either!

In fact, even if you assume all good things about Hostess -- free cash flow at the levels projected and growing at 10% annually, then at an enterprise value of $2.6 billion currently, and free cash flow of perhaps $133 million or so annually, I still see the stock as overvalued at an enterprise value-to-free-cash-flow ratio of nearly 20.

Long story short: I'm not on board with UBS' upgrade of Hostess stock today.

Rich Smith has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.

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