Illinois-based Treehouse Foods Inc. (THS.N) is behind many of the private-label drink mixes, sauces, jams, salad dressings and other products we pick up every day at the supermarket. Competition in this fast-growing business is warming up like a bowl of soup in the microwave as bigger players join the race. Can Treehouse thrive in a crowded kitchen?
The company is entering the single-serve coffee market, aiming at Keurig Green Mountain’s (GMCR.O) market share. Will this David’s sling be powerful enough to wound Goliath? Treehouse has also been acquiring several smaller players to expand its portfolio of products, but some of those markets have slimmer margins.
Looking at the StarMineEarnings Quality model, Treehouse scores a poor 10 (out of a possible 100), which indicates that earnings may not be coming from sustainable sources. We look at some of the indicators of poor earnings quality.
Source: Eikon/StarMine
Swallowing falling margins
Operating efficiency is one measure by which we gauge earnings quality. As you can see in the chart above, operating profit margins have been falling. Part of that is lower-margin product and part is higher operating and integration costs as the company acquires firms such as Flagstone Foods (healthy snacks) and Protenergy Natural Foods (soups and broths). In fact, trailing 4Q operating profit margins are at a five-year low of 7.4%. Meanwhile, the industry median operating profit margins have remained stable at around 9.5%.
While the acquisitions may help earnings in the future, for now it has meant that Treehouse is seeing a declining return on net operating assets. In the most recently reported quarter, the RNOA was at a five-year low of 8.1% compared to the industry median of 13.3%. Acquisitions in an environment of falling operating efficiency could lead to wealth erosion.
Source: Eikon/StarMine
Chewing on increased debt
Many companies occasionally report proforma earnings that differ from GAAP earnings, asking investors to ignore certain items are considered one-time or not part of the core business. Treehouse Foods has consistently seen proforma earnings below GAAP results, and GAAP results tend to win out in the end and tend to be a more accurate judge of future earnings.
In the last quarter, the company reported proforma earnings of 89 cents per share, compared to GAAP earnings of 47 cents per share. That represents the ninth consecutive quarter that Treehouse has reported proforma earnings more than 10 cents per share above GAAP earnings. While the exclusions may be justified (be it acquisitions, onetime tax charges or stock-based compensation), we believe that it could be a sign of poor earnings quality.
The rise in debt levels and thus interest payments, as well as goodwill (which represents the amount by which Treehouse overpaid for acquisitions on the balance sheet), are also likely to rein in future acquisitions.
There are several “buy” recommendations on the stock as a way to play the M&A scene or hope that acquisitions pan out as planned, but earnings quality may be a headwind.
Treehouse is trading at a forward P/E of 20, above its five-year median of 18, indicating that the company may not be cheap. It may need to heat up all burners and need acquisitions to work out efficiently in order to justify the lofty valuations. The question for investors may be – how tasty is the stock?
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