Blue Buffalo Pet Products (BUFF) continues to display solid operational momentum in a pet market which has seen a bit of a slowdown in recent times. Despite continued topline sales growth shares have been stagnant since the public offering in July of 2015.
This means that valuation multiples have gotten more appealing, although they remain elevated. At the same time it should be said that the balance sheet has been strengthened in a substantial way. Despite these observations, strong margins, good brands and solid outlook, I do not think that shares offer compelling value at these levels.
To see appeal, I will await a potential retreat to the mid-to high teens, levels at which I would become an accumulator of the shares.
Blue Buffalo's Business
Blue Buffalo has grown relatively rapidly in recent years in the market for pet food. The company has been founded in 2002 by the Bishop family as their dog ¨Blue¨ died from cancer, inspiring them to create healthier pet food. Billy Bishop, which has founded the company, will become the CEO in early 2017 after current CEO Kurt Schmidt has successfully built out the business in recent years.
The company managed to grow sales from 0 in 2002 towards $100 million by 2009. Ever since revenues have increased again by a factor of 10 times, surpassing the $1 billion mark in 2015. This revenue base gives the company a 6% market share in the US market for pet food.
Given that Blue Buffalo is a premium price product, and holds a leading position in the natural market segment, its volume share is much smaller, estimated at 2-3%. Gaining further market share is a top priority as the company competes against formidable players such as Mars, Nestlé and J.M. Smucker, among others.
Besides offering compelling products, the company is aiming to grow through another set of initiatives. The company aims to widen its channels, focusing on online outlets and farm & feed channels. Another priority is foreign expansion as international sales make up just 4% of total revenues at the moment.
Rapid Growth Slowed Down, But Remains Solid
Since the IPO at $20 in the summer of 2015, shares have largely traded flattish, currently exchanging hands at $22 per share. Investors have seen some volatility however, with shares trading in a $15-$25 range ever since.
Spectacular growth has slowed down over time. As the company grew, it became harder to maintain percentage growth rates although the absolute dollar increase in revenues has slowed down as well. Revenue growth for 2015 slowed down towards 12%, after sales were up by 27% in 2014. Based on the full year outlook for 2016, sales are expected to increase by 11.5% again, marking a real stabilization in the pace of growth.
This is encouraging as margins are stabilizing and improving as well following some pressure in recent years. Operating margins surpassed 20% in 2012 and 2013, but these margins did not prove to be sustainable. Operating margins fell back towards +15% in 2015. The company has made real progress this year alongside topline sales growth, scale efficiencies and absence of IPO related costs.
Margins came in at 22% for the first nine months of the year. This excludes a $32 million settlement charge relating to litigation pursued by Nestlé's Purina business, which alleged that Blue made incorrect advertising claims regarding its ingredients.
The Valuation, Remains Steep Despite Continued Growth
The combination of stabilized and solid topline sales growth, margin expansion and a reduction in leverage, results in much greater earnings potential. The underlying composition of growth remains impressive with third quarter volumes increasing by more than 9%, as pricing contributed little over 2% to reported sales growth.
Based on the current trends, Blue Buffalo is on track to post sales of $1.145 billion this year, and adjusted earnings of $0.78-$0.79 per share. This earnings metric is quite reliable as it really only ¨adjusts¨ for the litigation expenses. At $22 per share, such earnings potential still translates into a 28 times multiple.
The good news is that retaining earnings has bolstered the balance sheet. Holding $316 million in cash, Blue Buffalo operates with a very modest net debt load of $70 million, for a mere 0.2-0.3 times leverage ratio.
With 200 million shares outstanding, trading at $22 each, Blue Buffalo now trades at a $4.4 billion valuation. That is equivalent to 3.8 times sales. Equity and shares furthermore trade at 28 times earnings and at 15 times adjusted EBITDA, not very cheap multiples either. With many competitors being in private hands, or being active across a range of businesses, it is hard to find comparable valuations, yet one prominent deal comes to mind.
J.M. Smucker bought Big Heart Plan in a $5.8 billion deal in 2015 at a 2.5 times sales multiple, indicating that Blue Buffalo does indeed trade at premium multiples. This results from the solid margins and growth of the business.
Concluding Remarks, Appealing Business, Fully Priced
The sentence above says it all. Blue Buffalo is a great business and has done well in 2016, yet the valuation is reflective of that. That being said, shares have exhibited quite some volatility as a return to the mid-teens, with shares trading at $16 in January of this year, surely offers appeal.
Given the current earnings numbers, shares would trade at 20 times earnings at such levels. That looks appealing given the 10% revenue growth, strong prospects and unleveraged balance sheet.
As a result, Blue Buffalo continues to deserve a place on my watchlist as the business is sound and continues to deliver on solid growth. If shares retreat to the mid-to high teens I will start accumulating shares on the back of these fundamentals. Investors might furthermore be pleasantly surprised to see large and incumbent competitors looking for growth in an industry, as a potential M&A premium can never be ruled out.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
