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 employees. Many food companies including Flowers’ main competitors and companies in other industries use independent distributor business models, so this isn’t a risk that is unique to the company.
Classifying its independent distributors as contractors rather than employees saves these companies from having to pay overtime wages, Social Security and Medicare taxes, and unemployment.
In the company’s 10-K, Flowers states that, “Given the stage of the complaints and the claims and issues presented, the company cannot reasonably estimate at this time the possible loss or range of loss, if any, that may arise from the unresolved lawsuits.”
The company has classified its distributors as independent contractors since the 1980s and could face substantial changes to retroactively compensate these workers as employees, as well as major costs to buy back distribution routes and trucks from its contractors (independent distributors own the distribution rights in a specific geographic market). However, the notes receivables that Flowers took to finance the independent distributor’s purchase of the route and truck from Flowers would substantially offset the cost of buying back the routes and trucks.
Lawsuits notoriously take a long time to be resolved, but it’s hard to know how things could play out. In 2015, FedEx was forced to pay $228 million to its 2,300 delivery drivers working in California as they were deemed to be improperly labeled as independent contractors from 2000 to 2007. The case took 10 years to resolve but turned out to be very costly.
At the end of the day, we view the lawsuits to be a low probability, medium severity type of event that will likely offer little clarity for a number of years. While it’s easy for contractors to join class action lawsuits against the company (little effort is required but there could be a financial reward), that does not increase the legitimacy of the cases against Flowers. It’s also worth repeating that virtually every major play in the industry faces the same independent contractor classification issues, not just Flowers.
We are willing to give management the benefit of the doubt and believe that the company also has plenty of financial firepower to make it through any potentially adverse rulings, however unlikely they might be.
Dividend Analysis: Flowers Foods
We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend. Flowers Foods’ long-term dividend and fundamental data charts can all be seen by clicking here.
Dividend Safety Score
Our Safety Score answers the question, “Is the current dividend payment safe?” We look at factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.
Flowers Foods has a strong Dividend Safety Score of 73. The company’s dividend has consumed 65% and 39% of its earnings and free cash flow, respectively, over the last 12 months. Considering the predictable nature of selling bread and other baked goods, these are very healthy payout ratios.
As seen below, Flowers payout ratios have increased a bit over the last decade but have mostly been stable, underscoring the quality and reliability of the business.
As we mentioned earlier, most of the company’s products are needed by consumers regardless of economic conditions. Flowers’ revenue fell by just 1% in fiscal year 2010, and the company’s reported earnings grew each year during the recession. FLO’s stock also returned 6% in 2008, outperforming the S&P 500 by 43%. Flowers is clearly a recession-resistant business, and it’s no surprise why consumer staples is one of the best stock sectors for dividends.
Flowers’ dividend safety is also enhanced by the company’s consistent free cash flow generation. The company has generated positive free cash flow in each of its last 11 fiscal years, a sign of a healthy business that can sustainably pay and grow its dividends.
Flowers’ has also earned a strong and steady return on equity in the mid- to high-teens most of the last decade. The company is earning great returns for shareholders and can compound its earnings at a faster rate than many other businesses.
Looking at the balance sheet, Flowers has a lot of debt on hand ($1 billion) relative to its cash ($14 million). However, the company’s dependable cash flows reduce its credit risk profile considerably. Standard & Poor’s upgraded the company from a BBB- credit rating in September 2015 to BBB, and Flowers also has over $320 million available at its credit facility.
Overall, we think Flowers’ dividend payment is very safe. Investors will be challenged to find a more predictable industry than baked foods, and Flowers is well positioned with leading brands and meaningful economies of scale.
Dividend Growth Score
Our Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.
Flowers’ Dividend Growth Score of 81 indicates that the business has stronger dividend growth potential than most stocks in the market. Management most recently increased the dividend by 9.4% and has grown the company’s dividend for more than 10 consecutive years.
Flowers’ dividend has grown at an 18% compound annual growth rate since 2004, and the annual payout increased from 9 cents per share to 57 cents from 2004 through 2015. We expect the dividend to continue growing at a mid- to high-single digit rate, about in line with earnings growth.
Source: Investor Presentation
FLO’s stock currently trades at 18x forward earnings estimates and has a dividend yield of 3.2%, which is meaningfully higher than the stock’s five-year average dividend yield of 2.6%.
We believe Flowers can continue growing earnings at a high-single digit rate as it continues consolidating the fragmented U.S. baked foods industry. Under these assumptions, the stock appears to offer annual total return potential of 10-12% per year. Compared to most stable companies in the consumer staples sector, Flowers’ valuation looks relatively attractive.
Flowers shares many characteristics with some of our favorite blue chip dividend stocks. The company competes in a large, fragmented market with recession-resistant products and a slow pace of change. Flowers also has a leading portfolio of brands and benefits from economies of scale. We think the stock is reasonably priced today and will continue delivering steady, growing dividends for many years to come.