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Flowers Foods – A Contrarian View of a Popular DGI Stock

In this post I’d like to discuss a contrarian view of a popular stock within the DGI communityFlowers Foods – based on a look at risks within the ongoing driver independent operator (IO) misclassification lawsuits as well as other macro trends impacting the packaged bread industry, and what impact that could have on Flowers’ bottom line in the future.

First, the problem with Flowers Foods (FLO) is definitely not Dave’s Killer Bread, especially toasted with butter on it.

(I’m eating a few pieces right now, in fact… and it tastes kind of like how I might imagine crack might)

The problem with FLO isn’t that it’s gone on sale bigly, having plummeted – I think that’s probably the right word – more than $26 in November 2015 to around $15 today.

And the problem most certainly isn’t their 4.2% yield, or the fact that they’re probably the best managed direct store delivery (DSD) operator in the industry.

It’s in part due to these positive facts & metrics, I think, that FLO has lots of knowledgeable and well-respected investors calling it a “bargain dividend stock” and a “risk worth taking.”

But is it?

Let’s dive a little more into the reasons underlying its’ underperformance this year.

[divider]

To understand the contrarian thesis, let’s start by taking a look at Flowers stock performance to date:

2016-09-21_0842

(Source: Yahoo Finance)

On February 4, 2016 (indicated by the red arrow in the above chart), when Flowers was trading at about $20/ share, a majority of analysts had Flowers as a “buy.” In fact, at this time there was one analyst – just one – with a sell rating. More on him in just a moment.

A few days later, Flowers Foods tumbled 17%. The reason for the decline ostensibly was a sales decline of 2.2% in the quarter, and EPS which fell 20%, missing analyst estimates.

Often missed expectations can be a great opportunity to get into a business you like at a lower price, so for a long term value minded investor, this might not be such a bad thing.

Flowers provided guidance projecting positive revenue growth of 5.5%-8% to $3.99-4.08 Bn. And on the bottom line EPS growth of 6.5%-13%, or $0.98-$1.04, up from $0.92 in 2015.

Despite this positive guidance, the stock has gone nowhere. Missed expectations aren’t really the real issue.

When a stock drops rapidly, despite having such positive guidance, it’s worth looking into whether the fear underlying the decline is justified, or not. Sometimes it isn’t, but often you may find, it is.

Going back to the aforementioned analyst, I pulled this report from our lone analyst contrarian Timothy Ramey of Pivotal Research, who explained late last year in very clear language his opinion for the real reason for the decline, and if you’re long the stock or considering it, I think it’s still worth a read to wrap your head around some of the potential downsides:

Flowers Foods report by Michael Ozanian on Scribd

tl;dr

Here’s the tl;dr version of the article:

  • There are a bunch of pending lawsuits against Flowers by drivers saying they were wrongly classified as independent contractors, when in fact they should have been classified as employees.
  • In truth, you could argue that Flowers relationship with drivers since the 1980s have looked a lot like employer/ employee relationships. By definition an independent contractor is someone who does not take direction on how a job is to be completed by the employer. Yet Flowers often will tell the drivers that they have to add a certain store to their route, for example. This by definition is not how an independent contractor agreement should work.
  • If Flowers loses just one of the many growing lawsuits which as above do seem to have some merit, this according to Ramey will open the floodgates of lawsuits, and the routes will “reconvert” from independent to company owned. If this happens, $180 million in the distributor notes Flowers holds on the balance sheet which will just evaporate into nothingness. Flowers will be required to buy back routes under their agreed formulaic 10x sales. The route buybacks could cost about $471 million, and the awards to IOs and attorneys fees, etc might range between $500M – $1Bn.
  • This is the real 800 pound gorilla in the room, says Ramey. They cannot lose one of these lawsuits EVER due to the opening of the floodgates and consequent impact on the balance sheet.
  • In this scenario, pro-forma EPS would drop to $0.30-$0.35, from $0.98, making this a sub $10 stock overnight.
  • When you add to the risk from the class-actions as described above to the fact that this is a low margin, intensely competitive business with macro force headwinds, the current valuation of ~$15 remains optimistic, and somewhat excessive.




Takeaways

  • I don’t think the IO misclassification suit can be so easily dismissed which seems to be the consensus opinion in the articles and comment sections that I read around the blogosphere. There is not a parallel between other similar misclassification lawsuits I see referenced like Fedex due to the unique nature of the contracts Flowers has with their IOs, and Ramey I think in the report does a solid job of showing how the costs to buy back the routes may in fact be more costly than many people might realize.
  • If you look at Flowers balance sheet, you’ll see that Flowers keeps almost no cash on the balance sheet, relative to nearly a billion dollars in debt. This in itself isn’t really a problem. Ramey says they’re reasonably capitalized, which would keep the business from going under in this negative scenario. However, if you theoretically had a perfect storm where they lose one of these suits (that opens the floodgates and sets in motion some of the costs as described above), combined with some of the more macro issues outlined in the article – say if commodity prices start to rise – it seems you might potentially get into a “perfect storm” situation where you could – like Hostess – become undercapitalized and lose the business.
  • Like any investment, there is risk and reward that needs to be considered, and anything could happen. That said, I don’t think the risk side of the equation to date has been as deeply considered as it should. If you think that the above issues described above are in fact nothing to worry about, then yes, Flowers would appear to be a bargain stock and a good long term buy. But if you think the misclassification issue as outlined in the article has merit, then you could argue that Flowers is in fact a ticking time bomb. It’s a bomb that might not go off in the next month, or the next year, but at some point, it will likely happen. Ramey argues as much. This is why I do not think Flowers, while potentially a buy in the short term, could not even remotely be considered a long term “sleep well at night” holding.

As for me, from the research, a review of the balance sheet and risks outlined in the 10-K, and divergent opinions I’ve seen so far, I’ve chosen to keep my involvement in Flowers limited to going to the store, buying and toasting their Dave’s Killer bread now and then, slathering copious amounts of butter on it, and loving life & enjoying my weight gain along the way.

So what’s the point of all this? To make people afraid for no reason? No. Really it’s just to put this info out there as a contrarian point of view, not for contrarian’s sake, but because these are not issues I’m seeing deeply considered in the community right now. Rather, I just see comments like “great buy,” without much more discussion.

It is my hope that this information will inspire some consideration – and hopefully not to great irritation by longs –  and some more detailed discussion among us all given that this is seemingly such a popular buy in the community right now.

What say you? Are the risks in this analysis overstated? Is the bullish consensus opinion right? Or do the contrarian bears maybe have a point?

Disclaimer: As with everything on this site, information is provided ‘as is’ and solely for informational and entertainment purposes, not for trading purposes or advice. I am not a licensed investment advisor or investment professional. I make no representations as to accuracy, completeness, recentness, or validity of any information in this article and will not be liable for any errors, omissions, or delays in this information or any losses, injuries, or damages arising from its use. Please do not rely on this data for tax purposes. Unless your investments are FDIC insured, they may decline in value. Please consult with an investment professional before investing any of your money.

Full disclosure: I have no positions of any sort in any of the securities mentioned in this article.

Thanks for stopping by!

10 Comments

  1. I’m not really familiar with the company, or the circumstances it’s in. But I really like how you set up a different style of analyzing a company. It gives a different view as normally seen with stock analysis. As for as I can judge based on your article, the pending lawsuits and the dire situation of it, would mean a too great of a risk.

    • Greg Gee

      Hey Divinomics,

      There is risk inherent in any investment, and my hope with this was just to share what I think is a risk for anyone considering Flowers, and some more details around the potential implications of losing a misclassification lawsuit. All the while recognizing that it’s a great company with great brands.

      However, as Ramey himself states, “If Flowers loses, it will lose big, in our opinion. It goes back to the notion that the company has really bet the farm on maintaining the status quo. A reasonable analyst would have a hard time taking that bet, however. We might be early, we might be wrong as to timing, but we don’t believe we are wrong as to the ultimate outcome.”

      I personally agree with him, although I doubt anything will happen for a while yet. I guess we’ll see – like all our bets – how it all shakes out in the future.

      Thanks for the nice words & stopping by!

  2. JC

    Thanks for the detailed look at FLO. This is definitely something that all investors in FLO need to be concerned about because there’s a big risk of blowup proportions. I’d seen FLO being purchased by lots of other bloggers after the big drop in August and I’ve stayed away thus far because I hadn’t done the research on them yet. Just looking at the company/price action FLO is likely a buy but you’re betting that none of those lawsuits go against FLO. Should be interesting to follow and maybe someone more knowledgeable in business/contract law could have a better perspective on the likelihood of a judgement going against the company. For me though I think it’s best to remain on the sidelines, but selling OTM puts could be a way to get a lower share price and earn some option premium.

    • Greg Gee

      Hey JC,

      I actually had a conversation recently with a friend of mine on this exact topic and when I mentioned why I was staying away, he did not agree with the premise in the near term and said there were some options whereby he could hedge risk of this happening. OTM puts are a great way to get a stock at a better price while earning some extra income. But in a worst case scenario this could of course be dangerous. So there are ways to play this if you think that the current valuation is excessive.

      With regard to likelihood, I am not a lawyer but by definition an independent contractor has no right to control HOW the driver completes the task assigned to them, just that the task is completed. Meanwhile, drivers are held to a schedule, Flowers negotiates all terms of the retail relationship, drivers must follow all Flowers instructions, and Flowers can discipline workers for taking time off. Sounds like an employer/ employee relationship.

      Meanwhile Flowers is being sued by 190 of its 5,100 independent contractors (3%). All it takes is to lose one. Ramey does a good job of breaking down the rest.

  3. I wasn’t really aware of the Uber style “drivers counted as independent contractor” problem. Labor disputes are one thing. Labor disputes that fundamentally cut to the core of how the business costs are structured are another…

    I didn’t drink the FLO kool-aid because I don’t trust the balance sheet/cash flow situation. As you stated, $1B in debt is not that big a deal in and of itself, but taken in context of some of the other financial metrics, it is no bueno. They have basically no cash, so that debt burden leads to a pretty big negative net cash position relative to market capitalization.

    I’d be okay with that if they generated a ton of free cash flow, but that’s just not the case. FCF is not robust enough to support that kind of leverage IMO, but then again, I’m kind of a debt prude.

    Thanks for posting a “contrarian” position. The DGI blogosphere could use more of it.

    • Greg Gee

      Hey Catfish Wizard,

      Like the name and what you’re going for with that!

      Flowers has historically maintained very minimal cash on its balance sheet, while generating pretty good free cash flow. Fitch projects this at $95 million in 2016 decreasing to $80 million in 2017. However, as evidenced by their $120 million share repurchase program earlier this year, they have demonstrated a willingness to deploy this cash flow towards share buybacks instead of debt reduction (following its acquisition of Daves Killer Bread and Alpine Valley).

      Thanks for the support. I wasn’t sure how it would be received given how popular the stock has been recently.

      Take care!

  4. fred

    Thanks for this in-depth look at FLO.
    I too have read many DGI blogs touting FLO as a great buy just because the price had dipped and poo-pooing the lawsuit issues. Most DGI blog analysis seems limited to “well, the price dipped a couple bucks, now’s a great time to load up on this big yielder”. I’m a much more patient/skeptical type. I know being too anxious to buy any dip is often a sign of inexperience. Interesting too that the analyst you highlighted has deep industry experience having worked previously at Sara Lee.

    • Greg Gee

      Fred –

      Yes, I think in the DGI community this article outlines the contrarian view, even though I link to an article in the same day this came out on SA saying the bullish case was contrarian. I guess everyone likes to think they are a contrarian! 🙂

      In any event, I obviously agree & think as you say the issue is more complex than just – “price dropped, on sale.” In other articles, I see some discussion around the misclassification lawsuit, which in almost all cases doesn’t go into much analysis & ends with a diagnosis of “not that big of a deal.”

      To me it looks inevitable that at some point down the road, they’ll lose a lawsuit. Then the question comes down to what impact this will have on their business. Reasonable people can disagree, and I think the report lays out the downside scenario as well as some other macro risks quite well. As such, despite the price drop and feeling of the stock “being on sale,” I feel in the long run Flowers Foods current valuation is quite excessive in light of the risk investors are taking.

      Thanks for stopping by & sharing.

  5. I’ve honestly been somewhat perplexed by FLO becoming a DGI darling. They generally make junk and junk that is not even very popular anymore. They may stay in business, but I have a hard time understanding their future growth.

    Those debt ratios have to also be a tad concerning for investors. Nice to point that out.

    • Greg Gee

      Hey DS-

      Certainly paleo & carb-free is a real movement. Whether what they make is “garbage” is probably relative to your own dietary preferences and tastes. 🙂

      Yes, debt isn’t a problem in and of itself, but it is something to be aware of in light of some of the scenario mentioned in the article.

      Apparently I’m not the only one with some concerns. Thanks for sharing.

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