Flowers Foods (FLO) is a reliable company in the consumer staples sector that currently offers a reasonable valuation, a safe 3.2% dividend yield, and above-average dividend growth potential.
The business has been very good to shareholders over the last decade as well. FLO’s stock delivered a 12.9% annualized return from 2006-2015, handily beating the market’s 7.4% annual return.
The company’s annual dividend payments also ballooned from 9 cents per share in 2004 to 57 cents in 2015, representing an 18% compound annual growth rate.
Flowers was founded in 1919 and has grown to become the second-largest producer of packaged bakery foods in the country with nearly 50 operating bakeries. The company primarily sells breads, buns, rolls, tortillas, and snack cakes, and some of its key brands include Nature’s Own (the number one bread in the U.S.), Tastykake, Wonder Bread, Whitewheat, and Dave’s Killer Bread.
Approximately 84% of Flowers’ sales last year were Direct Store Delivery, in which fresh products are delivered directly to consumers via a network of more than 5,000 independent distributors. Roughly 78% of this segment’s sales are made to retail customers (e.g. supermarkets, mass merchandisers), who sell Flowers’ bread, buns, and rolls under Flowers’ brands and their own store brands in some cases. The remaining customers are mostly restaurants and institutional businesses.
The remaining 16% of revenue is derived from Warehouse Distribution, which includes fresh and frozen products that are shipped to customers’ warehouses nationwide. This segment is almost equally split between retail and foodservice customers.
Bread is boring, but as Warren Buffett would surmise, boring can be beautiful. According to Flowers’ investor fact sheet, approximately 98.6% of households buy fresh packaged bread. Bread is also the number one grocery category in weekly true profits.
The products Flowers sells are going to remain relevant and in demand by practically every household in the country for many years to come. We like industries with a slow pace of change, and Flowers’ business certainly checks that box.
While there are seemingly few barriers to entry in the industry, Flowers derives several advantages from its longevity (the company is nearly 100 years old).
Flowers has built up a large handful of brands with strong recognition over several decades. For example, the company’s Nature’s Own brand was introduced in 1977 and has built a strong reputation by never using any artificial flavors, colors, or preservatives in its baked foods since inception. Nature’s Own is now a $1.1 billion brand that is number one in the U.S. in sales of both white and wheat loaves.
With over $20 million spent on advertising each of the past three years, Flowers defends its market share in part due to favorable brand recognition with consumers. Smaller rivals don’t have the budget to build up competitive brand awareness.
Retailers also have strong relationships with Flowers and only have so much shelf space for the categories that the company participates in. As long as Flowers’ baked foods continue selling, there is little incentive for retail customers to give shelf space to unproven new entrants in the market, especially given the relatively low level of differentiation in a category such as bread.
Since product differentiation is generally perceived to be lower, maintaining an efficient production and distribution system is particularly important. As the second largest player in the market with just under 20% share (see below), Flowers derives several cost advantages.
Source: Investor Fact Sheet
The company enjoys economies of scale in purchasing its raw materials, mass producing its bakery foods, investing in efficient production facilities, and distributing its products.
Importantly, Flowers’ size has also helped it strategically locate production facilities near key markets, resulting in fresher products at the time of delivery and logistics cost savings. Many of its fresh products require frequent deliveries to keep store shelves well-stocked, which rewards suppliers with the densest and most convenient distribution networks.
Despite the company’s strong brands and economies of scale, its market is mature and has a low organic growth profile. As a result, Flowers has been consolidating the market for many years.
According to a recent investor presentation, the company has made more than 100 acquisitions since 1968. Flowers has made 14 acquisitions over the last decade that have added $2 billion in revenue, highlighted by its acquisitions of the Wonder Bread brand from Hostess Brands and the Sara Lee brand in California. Otherwise, Flowers has mostly focused on buying up regional baking companies in areas where it has not previously had much of a presence.
The largest player in the industry, Grupo Bimbo, has also helped consolidate the market. In 2011, it bought Sara Lee’s fresh bakery segment in North America. The three biggest players in the industry now account for over half of the market, which has encouraged more rational pricing.
Acquisitions have also helped Flowers enter faster-growing segments of the market to stay on top of changing consumer trends. The company now claims to have the leading position in the organic segment of the $2.1 billion specialty/premium loaf category through its acquisitions of Dave’s Killer Bread and Alpine Valley Breads. These brands are expected to combine for 2016 sales of about $255 million at the mid-point of management’s guidance, representing about 6% of total expected revenue.
Overall, the company’s management targets long-term sales growth of 5-10% per year (organic 3-5%, acquisitions 2-5%), EBITDA margins of 11-13%, and double-digit EPS growth. Bread might be boring, but its investment potential certainly is not.
Flowers Foods’ Key Risks
Flowers has built a very impressive network of bakeries and portfolio of brands over the years, significantly increasing in size. The company notes that it has expanded from serving 35% of the U.S. population in 2004 to more than 85% of the population in 2016, more than doubling its revenue from $1.5 billion to $4 billion along the way (largely driven by acquisitions).
In a mature category such as bread (the overall fresh packaged breads category as measured by IRI was up 1.1% in dollars and down 0.8% in units in 2015, essentially treading water), there is only so much market share available for the taking.
While the company’s sales have compounded at an 8% annualized rate over the past decade, future growth could be more challenging to come by.
If acquisitive growth becomes too expensive or there are no longer enough needle-moving deals with independent / regional bakeries, Flowers’ growth rate will slow down (Flowers’ organic sales growth was just 1.2% in 2015). The company might also feel pressure to enter adjacent markets to continue expanding, which creates opportunities and risks.
Evolving consumer tastes could also impact the company’s results over time. Consumers are increasingly moving away from gluten and desiring fresh, healthy foods over packaged items with questionable ingredients.
We expect bread to remain a massive category and aren’t particularly concerned by this risk, especially given existing expectations for low organic growth in the industry. However, it’s worth monitoring.
Another risk facing Flowers is the 18 lawsuits that have cropped up in recent years challenging the company’s classification of its distributors as independent contractors rather than