Twinkies were an integral part of Archie Bunker's lunch bucket. Google "All in the Family" if you are too young to remember what I'm talking about. Saturday Night Live even paid homage to the fattening delights by creating a series of skits where Dan Aykroyd and Jane Curtain stuffed pillows in the back of their pants and mocked their undying love for the products.
So what happened to Hostess and what can we learn from its demise? The factors that precipitated the death of an iconic American brand are the subject of today's discussion.
Brands are Not Necessarily Moats
Investors commonly fall prey to the notion that highly recognizable brands hold a durable competitive advantage by nature; nothing could be farther from the truth.
To hold a true competitive advantage, a product or service must have durable pricing power. In other words, if the behavior of a consumer remains unaffected despite a history of price increases, then the product probably holds some form of moat.
For instance, Warren Buffett found that yearly increases in the price of See's Candy did not affect the amount of total pounds of candy that the company was able to sell. Contrast that with the price of various automobiles. I may prefer the idea of purchasing a Lexus as opposed to a Toyota; however if the price of a Lexus exceeds the amount that I am willing to pay for a vehicle, I will likely decide that a Toyota will sufficiently suit my needs.
Exactly the same is true with hotels. I may prefer the room accommodations, service and the restaurants at the Bellagio but if Caesar's offers similar services at a significantly lower price, most people will opt to stay at the latter hotel.
Few Food Products Have Moats
Many Americans grew up eating Planter's peanuts; the image of Mr. Peanut has been successfully branded into their psyche through the advertising efforts of the company. Personally, I am fond of the dry-roasted variety which I purchase through Sam's Club. In the past several years the price of these culinary delights has been steadily rising. In fact, the price has now increased to the point that my consumption has severely abated. As the price increased, I found that I started buying one large can rather than two. As the price continued to increase, I found that I frequently refrained from buying even a single can of peanuts. In other cases, I found myself buying an alternative nut, such as a bag of almonds which was now more attractively priced in relation to the peanuts. In other words, the price differential for buying a tastier, healthier nut became significantly less thus altering my behavior.
Businesses which do not have pricing power and experience significantly diminished unit sales as the cost of their products increases do not hold significant competitive advantages.
When I used to travel extensively in my work, I acquired a bad habit of stopping for coffee and snacks at various convenience shops. I found that my taste buds shifted towards Little Debbie products as opposed to a Hostess product strictly due to the large difference in price. For years I could buy a Little Debbie brownie for 25 cents while a Hostess snack was generally north of a dollar. At some point my consumption behavior became a direct result of price. I probably would have been willing to pay slightly more for a Hostess snack but once as the price difference reached a certain level, my behavior became permanently altered.
Simply stated, Hostess products did not hold a significant competitive advantage versus lower price alternatives once the price differential crossed a certain level.
Human Consumption Patterns are Subject to Change
One merely has to check the ascending income statements for Whole Foods (WFM) versus the stagnant profits of traditional grocery chains to acknowledge the fact that the behavior of consumers is subject to change. Many Americans have embarked upon a much healthier lifestyle; the high calorie, sugar-laden favorites of past decades have witnessed significant declines in popularity as a result.
Under the Obama administration, many school systems have embarked upon mission of offering students more nutritional lunches. Not only have the lunch-line selections become healthier, many schools have eliminated various snack foods from school vending machines and snack bars.
Hostess products are not the only victim of "the war on childhood obesity;" white macaroni has suffered a similar fate. Many students have now been introduced to whole-grain pasta and whole-grain bread while being required to include fruits and vegetables on their trays. School menus now list carbohydrate grams on their printable menus. For the record, I fully support such efforts in changing the eating habits of America's youth.
Low Cost Producers Usually Win
Buffett followers are familiar with his "self-professed" greatest investing blunder; specifically his outright purchase of the Berkshire textile mills which bears the holding company's name. Buffett failed to recognize that the American textile industry was doomed to failure do to an inability to compete with "low-cost" foreign competition. Asian competitors enjoyed minuscule labor costs when compared to the wages paid to their American counterparts.
The US furniture market is currently facing a similar situation. It is virtually impossible for America manufacturers to compete with their Asian counterparts who enjoy much lower labor costs. Astute US furniture manufacturers such as Flexsteel (FLXS) have adjusted their business models to incorporate reduced labor costs in an attempt to reduce the cost of goods sold for their products.
Berkshire Hathaway's (BRK.A) company-owned Nebraska Furniture Mart sources their products from all over the world in attempt to remain a low-cost provider of quality furniture. To maintain a legitimate competitive advantage most companies must be able to either produce or provide products at lower prices than their competition. Walmart (WMT) was founded on exactly such a principle.
Hostess was encumbered by extremely high labor and pension costs as well as being burdened by a high cost of capital which the company incurred as a result of its high debt load and its poor credit rating. Smaller rivals such as Little Debbie were able to achieve profitability while selling their products at a much lower price than Hostess products
Highly-leveraged Companies are Risky Propositions
The underlying risk of high debt loads is frequently cloaked by a company's current interest coverage ratio. A company can encounter unforeseen problems which can rapidly damage their credit rating or drop their interest coverage ratio to a dangerous level. Further, when a company must renegotiate their long-term debt there is no assurance that their interest rates will not rise significantly.
Many credit facilities are adjustable in nature; facilities tied to libor or prime plus a percentage can become increasingly expensive should rates start heading north. Such worries are seldom considered in the current environment of suppressed interest rates. That has not always been the case and investors should not fall prey to the notion that a highly-leveraged company will be terminally entitled to a low cost of capital in the form of favorable borrowing rates.
The demise for Hostess contained a multitude of factors. Its downfall was hastened by high labor and high borrowing costs as well as changes in consumer behavior. Eventually, the average price point of a Hostess product became too high in relation to its competition. Make no mistake, Hostess was still recording billions in revenues but those revenues simply were not providing sufficient operating margins due to the cost structure of the company.
When Hostess products resurface under different manufacturers, it is extremely likely that their popularity will once again emerge. The difference will be that either their price point will be significantly lower or their gross margins will be significantly higher. The most likely scenario will be a combination of the two aforementioned factors.
The lesson for investors is that even icons can go bankrupt if their business model begins to fail and their costs rise to a level that becomes unsustainable.
I leave you with one of my favorite movie quotes from one of my favorite movies, "The Hustler." Towards the end of movie after Fast Eddie dismantles Minnesota Fats in a pocket billiards rematch, Paul Newman's character turns to the character played by George C. Scott and utters: "Percentage players die broke too, don't they Bert?" Hostess was a percentage player that suffered exactly such a fate.