"Whole Earth Brands (FREE) – The Price Asks the Question
I started my career at Credit Suisse First Boston in the equity research department (covering the glamorous sector of freight railroads). I was lucky to sit down the hall from Michael Mauboussin, whose work I have followed and admired in the almost twenty years since. Two years prior to my arrival at Credit Suisse, Mauboussin had published Expectations Investing with his frequent collaborator, Alfred Rappaport. The thesis of the book is that, as an alternative to attempting to value a company in the traditional manner utilizing a variety of inputs and forecasts, analysts can and should invert the process, and ask what expectations are embedded in a stock at its current price. I have heard this distilled to the price asks the question.
There is a large group of companies in the market today (many software as a service, or SAAS) that are trading for more than twenty times their annual revenues. One example is a company that is expected to generate approximately $3.5bn of revenue in 2021. It has a gross profit margin of just over 50% and is expected to generate between $300mm and $400mm of EBITDA next year. It is a great business, and is growing rapidly, but the company has a $120bn enterprise value and is trading at 35x sales, 360x EBITDA, and 420x earnings (all on calendar 2021 estimates). There is a certain set of expectations embedded within this valuation (around growth, margin, operating leverage, and – with Mauboussin on the mind – competitive advantage period,2 etc). And in this example, those expectations are extremely high: continued rapid growth and ultimately something approaching total industry domination for decades.
This company’s price is asking some pretty difficult questions. I prefer the prices of our stocks to ask easy questions, perhaps those even a kindergartener could answer.
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Whole Earth Brands (FREE) is a packaged food and ingredients company focused on the “healthier for you” and “free from” segments (primarily non-sugar sweeteners) and the licorice-based flavorings segment (whose end markets include tobacco, vitamins, and confectionary). FREE is pursuing a “buy and build” strategy under the chairmanship of Irwin Simon, who built natural food pioneer Hain Celestial (HAIN) from under $20mm of sales in 1994 to over $2bn of sales last year. FREE targets moderate organic growth and industry-leading margins derived from its asset light model. It has dominant market share in France and parts of Europe with its Canderel brand, leading market share in its licorice-based flavorings business, and strong growth brands in its Whole Earth and Pure Via natural non-sugar sweeteners (the former grew 70% y/y in 1H 2020).
These leading brands should generate just under $300mm of revenue, ~$65mm of EBITDA, and over $1/sh of cash earnings next year. Yet, at a market cap of $300mm and an enterprise value of $385mm, FREE is trading at 1.3x sales, 6x EBITDA, and 8x cash earnings. An undemanding set of expectations is embedded in this valuation. Again, the price asks the question. Is FREE a challenged, low-quality business in secular decline, as the market’s valuation of it implies? Obviously, I believe the answer is no.
What might explain FREE’s seemingly remarkable valuation? FREE came public via a SPAC, an avenue that, with good reason, is generally hated by the market (with a few notable high-flying exceptions). Further, prior to coming public, the businesses that comprise FREE – Merisant and Mafco – were owned by Ron Perelman. It is no secret that Perelman has been an aggressive seller of his assets – from artwork to yachts to companies – over the last few quarters as he seeksto de-lever. His fire sale is our opportunity to profit.
Merisant and Mafco reportedly had over $350mm of debt (over 5x leverage) under Perelman’s ownership and Perelman’s empire had significant additional leverage, so historically the majority of FREE’s free cash flow was used to service that debt and pay out dividends to Perelman. Capital for integration, cost-cutting, brand-building, and growth was scarce. At 6x EBITDA, the market is pricing in decline, yet looking under the hood shows a business with secular tailwinds that is being set free from its debt shackles for the first time. Management will now be able to invest in the business to improve efficiency and drive growth. The fact that management has been buying shares in the open market suggests they are confident.
There are some parallels between the setup at FREE and that at our long-time holding Turning Point Brands (TPB) at the time of its IPO. TPB was also initially a “broken” IPO (although to be clear, there was nothing broken about the company), and was transitioning from meaningful leverage (5x+) to a less capital-constrained balance sheet, that would allow it to begin to invest for growth. TPB and FREE each incidentally own businesses that date back over 150 years. TPB’s Zig Zag (rolling papers) and FREE’s MacAndrews and Forbes (Mafco) were each founded in the 1850s, the latter by two Scots in Turkey to sell and distribute licorice root and licorice extract globally.
Packaged food and ingredient peers trade in a range of 8x - 18x+ EBITDA, with the most appropriate comps in the 9x - 13x range. If we apply the low end of this range to FREE, we would come up with a ~$14 stock (66% upside). At 11x EBITDA, FREE would trade for ~$18/sh (110% upside). Similarly, at 16x cash earnings, the stock would be a double.
As I see it, the biggest risk to FREE is that it rushes to do an outsized acquisition before the market has recognized the company’s potential. As long as FREE is trading at a double-digit free cash flow yield, it is likely to have no better use of capital than buying back its own shares. M&A involves risk and uncertainty, and I believe FREE would be hard pressed to find a business as compelling as its own for anything approaching 6-7x EBITDA (even after assumed synergies, which don’t always materialize as hoped). “Buy and build” strategies work best when companies make acquisitions at meaningful discounts to their own valuations. Over time, after FREE starts trading at a fair multiple, it will be able to kick start its acquisitive growth flywheel.
FREE seems to concur with this assessment. The company implemented a share repurchase program within months of coming public. The current authorization is for $20mm, or roughly six months of normalized free cash flow, which could reduce the share count by a meaningful ~7%. Three years at this pace – and this price – would of course reduce the share count by over 40%. And eight years, well…
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My kindergartener is starting to learn about the concept of multiplication. To make it concrete, we talk about groups of. “What is five groups of ten?” She knows that this is fifty. The price of Whole Earth Brands is asking questions that she can answer. “What is eight groups of one?” Or perhaps: “If I gave you $1 each year for the next eight years, how many dollars would you have?” Eight.
Okay, I rounded for my kindergartener. But if Whole Earth Brands can generate ~$1.10/yr in free cash flow (my estimate for 2021) for the next eight years (ignoring the organic growth and margin expansion that I think likely), it will have fully covered its current stock price/market cap. Investors could buy this business at today’s price, recover their entire purchase price in eight years, and then get to own the business over the ensuing decades for free. For a business that has already been around for 170 years, this seems like a tantalizing proposition."
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November 06, 2020 at 12:32AM
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Is Whole Earth Brands (FREE) a Smart Long-term Buy? - Yahoo Finance
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