Blue Is Ready To Rumble With The Big Dogs

My thesis on Blue Buffalo (BUFF) from August 2017
 
Blue Buffalo (BUFF) has all the characteristics of a capital compounder in a stable end market.  A 12% revenue/18% earnings CAGR over 2017-2020; a 25x NTM P/E and 15x NTM EV/Ebitda is highly attractive for a cash generative-dominant brand, with only 6% North America share and <1% global share, and multiple levers to pull in expanding distribution and insourcing production and optimizing capital structure.  We expect multiple expansion along the way as market appreciates the long run way for growth, high financial returns, and defensive business characteristics.  We believe BUFF has 60% upside (30x on $1.57 of 2020 EPS discounted back 2 years) and 16% downside.  Details below.
 
Checks off Key Criteria

• Stable/low growth pet food end market, natural/wholesome is the faster growing sub segment (10% CAGR)
  • Benefitting from “humanization of pets”
• High returns (30% ROE)
• Good historic pricing power
• Low capital intensity (2% of sales, 5% if I account of periodic plant builds or future Europe expansion)
• Sustainable free cash flow.  $750 - 800m of cumulative FCF from 2018-2020
• Low leverage.  Less than 0.5x net Debt/Ebitda
• Leadership brand.  Blue Buffalo is the largest and fastest growing natural pet food brand
• Strong management.  Built the brand from the ground up, consistent strategy, realistic guidance since IPO
• Positive change in P&L
  • Revenue acceleration in 2H17 and 18/17.  Success in Kroger/Target/Publix/Meijer leads to launch in rest of unpenetrated FDM (Food/Drug/Mass channel)
  • Gross margin acceleration from 2017-20, from 46% to 50%
  • Earnings acceleration
• Attractive multiple given above criteria and compelling for a staples allocator (3-5 year 18% earnings CAGR for 25x NTM P/E)

Downside support

• A rare growth gem in CPG with 6% of US share and less than 1% of global share
• Take out candidate if FDM execution does not go as planned
• NESN, SJM are large competitors, hungry for growth.  Both brands are share donors
• 20-22x Ebitda take out multiple based on past transactions for a unpenetrated, growth brand, providing strong downside support.  BUFF trades at 15x NTM Ebitda

Core competency and competitive advantage

• BUFF at its core is a shrewd brand builder and advertiser leveraging the natural/wholesome trend
• Founder and Chairman, Bill Bishop, has an advertising background, worked for several agencies and CPG companies
• He was the EVP at SOBE, which was sold to Pepsi in 2000.  Sales exploded from $1m to $225m from 1995-2000 due to differentiated product and advertising
• Co. spends 9-10% of revenues on advertising, has created a dominant brand with substantial mind share among pet parents relative to actual market share
  • Avg. CPG marketing spend is 3-5%
• Effective marketing is clearly driving revenue growth

End market and share

• $28b pet food market at retail growing 2-3% in US ($23b in wholesale by eliminating a 20% markup)
• $42b internationally
• Natural growing HSD and taking share across all channels
• BUFF is 6% of market, and less in pounds sold ($1.2b of a $23b market at wholesale)
• 15% share in e-commerce channel
• 20% of Pet superstore channel, most penetrated channel
• 8-12% in specialty and rural stores (TSCO etc.)
• Currently end channel penetration is 40%, FDM is 53% of market share

Why does this opportunity exist?

• BUFF is a leading pet food brand, but historically has been handcuffed by limited distribution.  57% of sales today are concentrated in Pet Superstores (Petsmart/Petco) and have been slowing->declining at an increasing pace due to well-known retail secular decline
• Exiting 1Q17, Co. sales were decelerating rapidly, guidance seemed too aggressive
• In 2Q17, Co. announced its FDM rollout into Kroger, Target, Publix, Meijer
• This breaks the distribution handcuff, and signals a full FDM launch in unpenetrated retail over the next 5 years as inevitable
• BUFF transitions from a decelerating to an accelerating stock

Revenue acceleration from FDM launch.  “consensus is too low”

• Rolling out in 8-9% of market via Target/Kroger/Publix/Meijer and Co. assumes 10% share at mid point
  • This conservatively amounts to $190 – 230m in revenues (16-20% revenue growth next year)
• Rest of FDM (40% of market) to be selectively rolled out once co. can assess current success
  • Retailers generate higher dollars/sq.ft. and improve productivity from a high turning premium brand (higher $/pound) such as Blue Buffalo
• BUFF can easily be 10% of overall market, which mean $2.3-2.4b in sales over 5-6 years
  • Current share in every channel is at or above 10%
• Consensus revenue numbers are too low even with conservative assumptions:
  • Assuming a 15% decline in Pet superstores (deceleration from current 5% decline)
  • Deceleration in other channels from 30% to 18% growth
  • $205m contribution in 2018 from FDM
• Revenues to conservatively grow 12% in 2018 vs. cons. at 9%
• Co. has publicly guided to 10% revenue growth, and controls FDM roll out pace to meet or exceed guidance. We expect 11% CAGR from 2017-2020
• International market is a growth option

Case for gross margin expansion

• GM to expand from 46% to 50% between 2017-2020 on the following

WTO (wet, treats, others) vs. dry mix

• Current BUFF business mix of dry/WTO is 80/20 vs. end market which is 60/40
• This is likely due to: 1) pet store concentration (lower treat incidence), 2) lower emphasis on treats business
• Product introductions and focus on improving WTO will also help mix
• Positive for gross margins

New facility

• New mfg. facility comes on line in Mid 2018
• GM jumped up 250-300 bps when last facility came online
• Expect similar impact in late 2018-19

New distribution

• FDM launch is accretive to gross margins
• Bad sizes are smaller vs. pet superstores
• WTO attachment is also higher in these channels

Earnings model

• We make the following assumptions
  • we are assuming slight SG&A leverage annually
  • we expect an EPS cagr of 18% from 2017-2020
  • tax rate of 37%, could be lower if any tax reform is passed
  • 1% annual share outstanding dilution

Cash Model

• Capex to normalize from $170m in FY17 to $25m thereafter

Low risk of retribution and share loss at Petsmart/Petco

• BUFF is the fastest growing premium brand, so high growth and high margin vs. alternatives
• Both risk further traffic losses if bestselling brand is de-emphasized
• Retailers have significantly less leverage today vs. the past (IAMs example)

Other Negatives

• Recent IPO, so only 8 quarters of public company history
• Recent CEO transition
  • However, current CEO, Billy Bishop was also part of Sobe, and has been involved with BUFF since inception
• Co. guidance for this ramp is conservative, so low probability but Co. could see short term risk to numbers if FDM ramp takes longer
• Brand damage from product recall mishandling
• Read-thru from history of product recalls, and Nestle lawsuit on false advertising suggests Co. can improve product quality control
  • http://www.petfoodindustry.com/articles/6334-blue-buffalo-supplier-charged-with-8-criminal-counts
  • http://www.petfoodindustry.com/articles/6113-purina-and-blue-buffalo-settle-lawsuits-after-two-years
  • https://www.dogfoodadvisor.com/dog-food-recalls/

 
Inventories and receivables

• Inventory management has been consistent in the 8 quarters of public data
• Avg. AR days rising sequentially, could be due to retailers maximizing cash cycle

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