Flowers Foods’ Key Risks
Flowers Foods, Inc. (NYSE:FLO) has built a very impressive network of bakeries and portfolio of brands over the years, significantly increasing in size. The company notes that it has expanded from serving 35% of the U.S. population in 2004 to more than 85% of the population in 2016, more than doubling its revenue from $1.5 billion to $4 billion along the way (largely driven by acquisitions).
In a mature category such as bread (the overall fresh packaged breads category as measured by IRI was up 1.1% in dollars and down 0.8% in units in 2015, essentially treading water), there is only so much market share available for the taking.
While the company’s sales have compounded at an 8% annualized rate over the past decade, future growth could be more challenging to come by.
If acquisitive growth becomes too expensive or there are no longer enough needle-moving deals with independent / regional bakeries, Flowers’ growth rate will slow down (Flowers’ organic sales growth was just 1.2% in 2015). The company might also feel pressure to enter adjacent markets to continue expanding, which creates opportunities and risks.
Evolving consumer tastes could also impact the company’s results over time. Consumers are increasingly moving away from gluten and desiring fresh, healthy foods over packaged items with questionable ingredients.
We expect bread to remain a massive category and aren’t particularly concerned by this risk, especially given existing expectations for low organic growth in the industry. However, it’s worth monitoring.
By far, the biggest overhang on Flowers is the 18 lawsuits that have cropped up in recent years challenging the company’s classification of its 5,000+ distributors as independent contractors rather than employees.
Classifying its independent distributors as contractors rather than employees saves the company from having to pay overtime wages, Social Security and Medicare taxes, and unemployment.
In the company’s 10-K, Flowers states that, “Given the stage of the complaints and the claims and issues presented, the company cannot reasonably estimate at this time the possible loss or range of loss, if any, that may arise from the unresolved lawsuits.”
The company has classified its distributors as independent contractors since the 1980s and could face substantial change to retroactively compensate these workers as employees, as well as major costs to buy back distribution routes and trucks from its contractors (independent distributors own the distribution rights in a specific geographic market).
Lawsuits notoriously take a long time to be resolved, but it’s hard to know how things could play out. In 2015, FedEx was forced to pay $228 million to its 2,300 delivery drivers working in California as they were deemed to be improperly labeled as independent contractors from 2000 to 2007. The case took 10 years to resolve but turned out to be very costly.
Tim Ramey, a sell side analyst with Pivotal Research Group, is particularly bearish on the lawsuits. In his report, he believes the company could be on the hook for $425 million to repurchase its routes from distributors, $260 million to repurchase trucks, and another $500 million to $1 billion for “back pay, overtime, workman’s comp, and punitive awards.” He pegs the total risk between $750 million and $1.25 billion.
While we never put much weight, if any, on sell side analysts’ opinions (they are paid for newsworthy headlines, not results), the potential magnitude of damages is noteworthy. This is the type of event that would likely impair the company’s long-term earnings potential because it would structurally reduce margins (employees come with more costs than independent contractors).
At the end of the day, we view the lawsuits to be a low probability, high severity type of event that will likely offer little clarity for a number of years. While it’s easy for contractors to join class action lawsuits against the company (little effort is required but there could be a financial reward), that does not increase the legitimacy of the cases against Flowers.
For now, we are willing to give management the benefit of the doubt and believe that the company also has enough financial firepower to make it through any adverse ruling, although the stock would likely get whacked on the news.
