NEIL A. MARTIN | BARRON'S ONLINE
September 17, 2007 – A decade ago, most people would have given Robert Harris a slim chance of getting consumers to use a new trans-fat-free margarine called Smart Balance (ticker: SMBL).
“We wanted to offer people a more heart-healthy alternative to the oils and spreads they were using at the time,” says the now-retired entrepreneur, who earlier had made a fortune by developing the Weight Watchers food line and then selling it to H.J. Heinz. But getting shoppers to switch from established brands such as I Can’t Believe It’s Not Butter or Blue Bonnet posed a daunting challenge — especially because it would mean wresting shelf space from their respective producers, giants Unilever (ticker: UN) and ConAgra (CAG), which controlled 75% of the U.S. margarine market at the time.
However, by tapping into consumers’ health concerns, Smart Balance the margarine has become a winner. That’s made Smart Balance the stock look appetizing.
In his battle against the Goliaths, Harris had some lethal projectiles in his sling — licenses to a patented blend of natural vegetable oils (palm, soy and canola) developed by researchers at Brandeis University, near Boston, that raise a user’s level of HDL (“good” cholesterol) to LDL (“bad” cholesterol), plus an extraordinarily fortunate bit of timing. He launched the product just as studies found that trans fats clog arteries, boosting the likelihood of heart disease.
Trans fats are created when manufacturers add hydrogen to vegetable oil, helping to extend shelf life and stabilize the flavor of foods such as doughnuts, French fries, pie crusts, cookies, cakes and, yes, margarines.
Because Harris already owned GFA Brands, a tiny Cresskill, N.J., food-marketing company that was selling a margarine, developing a new one using the Brandeis blend was relatively easy. The result: a butter-like spread that not only pleases the palate (it’s been rated the best-tasting margarine in national food-judging contests two years in a row), but also can make a health claim that its competitors can’t match.
Retail sales started relatively slowly — they amounted to about $3 million in 1997 — but as more shoppers become concerned about trans fats, more began trying the product. By 2002, Smart Balance had 3.4% of the $1.2 billion U.S. margarine market. By the end of 2006, sales had jumped to $138 million and market share to 11.4%.
The Smart Balance line has expanded to include bottled oils, cooking sprays, popcorn, mayonnaise and peanut butter, as well as natural and organic versions of the same products, sold under the Earth Balance brand.
“It’s a ‘Little Engine That Could’ kind of success story, but there was also a bit of serendipity involved in Harris’ initial success,” says Stephen Hughes, CEO of Smart Balance. The company is an outgrowth of Colorado-based Boulder Specialty Brands, a special-acquisition corporation created in May 2005 to merge with a high-growth, high-margin private healthy-food company and bring it public. That it did, acquiring GFA Brands from Harris and his investors, TSG Consumer Partners, last May for $490 million, with money from an initial public offering, private-equity sales and bank debt. Harris, who is in his 80s, retired after the merger, but until this year continued to peddle Smart Balance margarine in radio commercials.
A big boon for the spread came in January 2006, when the Food and Drug Administration began requiring manufacturers to list the percentage of trans fat on food labels, and recommended that people consume as little of the substance as possible. Less than a year later, New York City banned the use of trans fat by restaurants. Other major cities, including Boston, are preparing similar bans.
All these developments have created a terrific growth environment for Smart Balance. Sales grew at 30%-plus last year and continue to climb at that pace, says the 52-year-old Hughes, a food-industry veteran.
Smart Balance has recently whetted Wall Street’s appetite. The stock, which was listed on Nasdaq Aug. 1, after trading over the counter since the $8-a-share IPO, has risen almost 20% in the past 2 weeks; it recently was at 11.18. The apparent catalyst: an investment road show featuring Hughes and his chief financial officer, Robert Gluck, formerly Bestfoods’ CFO.
Still, there's no major sell-side research on the company, although several big securities firms are expected to initiate coverage this year. One independent researcher, CJS Securities of White Plains, N.Y., which supplies analytical reports to private clients (mostly small-cap investors), initiated coverage last month with a Market Perform rating and a target price of 15.
In the report, analyst Robert Labick advises clients to view the stock as a sort of public venture-capital situation, in which they’d be “investing side-by-side with executives that have an excellent track record, great industry contacts, a strong marketing team with attractive products…and a brand that could be significantly larger over the next few years.”
Professional investors have built large positions in the common, preferred and warrants issued by the company. There are currently about 30.4 million common shares outstanding, giving the company a modest stock-market value around $340 million.
The Bottom Line
Smart Balance’s shares, now above 11, could reach 15 or more within 12 to 18 months. But the real payoff might come later, in the form of a takeover by a large food company.
O.S.S. Capital Management, run by Barron’s Investment Roundtable member Oscar Shafer, has about a 10% position in the company, while Ron Baron’s Baron Capital Management owns about 5%. Hedge funds OZ Management and Glenhill Advisors have significant stakes, as well.
At ACK Asset Management in White Plains, which has about 1% of the stock, Managing Partner John Reilly III says the company’s big attractions are that it is run by a savvy marketer, “can grow nicely without much help from a strong economy and…has a growth-generating catalyst in the Smart Balance brand name and product line.”
The company, whose rights to the Brandeis blend won’t expire until 2015, has gone to court three times to defend its patents. One cookie maker that had copied the patented blend chose to become a Smart Balance licensee rather than reformulate or face litigation. “Sometimes, a liability can be turned into an asset,” says Hughes, who’s increasing patent vigilance, with the aim of boosting sublicensing income.
In 2007′s first half, Smart Balance lost $1.24 a share, mainly because of higher interest costs and the expenses related to the acquisition of GFA Brands. But on an operating basis, the company was profitable.
Reilly says that, using conservative estimates, Smart Balance should earn 16 cents a share this year, 55 cents in 2008 and 70 cents in 2009. “As they ramp up advertising, more people will become familiar with the brand and cash flow should really accelerate,” Reilly adds. Smart Balance plans to spend more than $40 million on advertising next year, versus 2007′s $28 million.
Over the next 12 to 18 months, Reilly contends that the stock will reach $15 to $22. “Longer-term, this legitimately could be a $30-to-$40 stock.”
This assumes that the stock can trade at a price/earnings multiple of 20 to 30 times, a level that is in line with most food and beverage companies. “That’s not cheap, but it’s not expensive, either, for a growth company with 50%-plus gross margins, revenues expanding at a 30%-plus annual clip and Ebitda [earnings before interest, taxes, depreciation and amortization] growing by 50%-plus a year,” says Stefan Mykytiuk, a portfolio manager at Pike Place Capital Management, which is long Smart Balance. “People at Kraft or Kellogg would jump up and down if they got 3% or 4% growth in a specific category of foods.”
The real end game for Smart Balance might be a takeover by a food giant seeking a fast-growing niche business. Says CEO Hughes: “That possibility is always out there, but for now we’re quite content expanding our niche and creating good-tasting, heart-healthy foods for consumers.”
Robert Harris’ mission continues.
ABOUT TSG CONSUMER PARTNERS LLC
TSG Consumer Partners, LLC is a leading investment firm with
approximately $5 billion of assets under management, focused
exclusively on the branded consumer sector. Since its founding
in 1987, TSG has been an active investor in the food, beverage,
restaurant, beauty, personal care, household and apparel & accessories,
and e-commerce sectors. Representative past and present partner
companies include Duckhorn Wine Company, vitaminwater, thinkThin,
popchips, Muscle Milk, Yard House, Stumptown, Pabst, Planet Fitness,
REVOLVE, PAIGE, Smashbox Cosmetics, Pureology, Sexy Hair, e.l.f. Cosmetics
and IT Cosmetics.
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