Can Sovos brands new to food stocks live up to their aggressive IPO?

By listing its shares for the first time on September 23, the agri-food company Sovos brands (NASDAQ: SOVO) ended up pricing its initial public offering (IPO) at a lower price than initially expected. But investors seemed to think the launch was to their liking and the stock price surged soon after, ending its first day of trading up more than 20%.

Despite the relatively bullish first day of trading, there are at least three reasons you might want to be careful before buying stocks in this newcomer to the food industry.

Image source: Getty Images.

1. Lower prices end up minimizing the profits Sovos hoped for

Sovos offers a branded menu including Italian cuisine, yogurts, and “healthier” pancake and waffle mixes. It has been around since 2017 and was founded by a food industry veteran who wanted to target remarkable products that could compete with the leaders in the category if they had the right support and the right opportunities. Sovos management filed for the IPO with the Securities and Exchange Commission in late August and ultimately set the expected share price range between $ 14 and $ 16. On the actual launch day, pre-IPO interest caused the actual IPO to drop to just $ 12 per share. The stock opened at $ 14.75 per share and traders offered it up to almost $ 15 in the first hour, a price that actually fell halfway through the initial price range. .

With the gains ending up in the pockets of traders, Sovos ended up with an initial valuation of $ 1.17 billion. Had he sold the 23.3 million common shares at the high end of the original range, he might have reached a valuation of $ 1.6 billion instead. In terms of gross proceeds it could use to fund future efforts, the IPO gave the company $ 280 million, rather than around $ 325 to $ 373 million.

2. Sovos goes public with a large debt

Sovos has a specific use of cash in mind. The company said it intended “to use the net proceeds of this offering to repay outstanding borrowings under our credit facilities and for general corporate purposes.” While Sovos does not provide any breakdown of how the proceeds will be allocated among these uses, the debt repayment list first suggests that more cash will be allocated to this than to “general corporate purposes.”

Sovos’ long-term debt rose 182% year-on-year, from $ 276.5 million to $ 780 million in mid-2021. Between late December 2020 and late June 2021, long-term debt surged about 125%. Sovos further says in its prospectus that it borrowed $ 905 million in June from Swiss credit and Owl Rock Capital Corp. It used $ 373.2 million to repay existing loans, but also “made a restricted payment for the purpose of paying a dividend in the amount of $ 400 million to direct or indirect shareholders” of Sovos Brands Limited Partnership , the separate partnership that owns the Sovos Food Brand Company.

Sovos, in short, does not primarily use the proceeds of its IPO to fund business expansion. Instead, shortly before going public, it borrowed nearly $ 1 billion and immediately paid out nearly half of that money to its owners as a “dividend.” Then it launched its IPO and allocated an unknown part of the proceeds to repay the debt incurred during the payment of this dividend.

Even though it uses part of the proceeds to reduce its debt, Sovos has a lot of influence on its balance sheet. Campbell Soup, another food brand manager that has seen its COVID-19 performance decline and a return to sluggish growth as the economy reopens, has a debt-to-equity ratio of 160. Other processed food companies include Publish credit notes with a ratio of 242, The JM Smucker Company. with debt to equity of 58, and Hostess brands with an approximate ratio of 67. Sovos leads all of these companies with a total debt ratio of 371, making it one of the most leveraged in the industry.

Boxes and containers of Sovos Brands including spaghetti, lasagna, pasta sauce, yogurt and pancake mixes lie on a white table

Image source: Sovos Brands.

3. Sovos’ performance is a positive, but there are caveats

Sovos’ financial performance includes an impressive 34% year-over-year increase in revenue for the first six months of 2021, to $ 351.2 million. However, the cost of sales increased by 37% over the same period. Its earnings before interest, taxes, depreciation and amortization, or EBITDA, fell from 15.7% to 13.1%. Its net income rose 14%, from $ 9.1 million to $ 10.4 million, while adjusted earnings per share fell from $ 0.12 to $ 0.13.

The company is growing and making sales, but its declining margins, rapidly increasing expenses, and weak EPS growth outweigh these positives to some extent. It also recently acquired one of its four brands, Birch Benders, which could affect its apparent performance. Birch Benders, which Sovos bought in October 2020, generated $ 32.5 million in revenue in the first 26 weeks of 2021.

Removing the Birch Benders effects from the equation cuts revenue growth to 24% – still substantial, but also indicating that net profit and EPS could also have been lower, perhaps even down year on year. the other without the contribution of Birch Benders.

Sovos has advantages, but investors should be careful

While the stock market has apparently found the Sovos IPO appealing, at least initially, there appear to be plenty of reasons to be cautious of the company. Its growth is positive, but many other companies have higher margins, more effectively turning their income into profits. The proceeds of its IPO, rather than being funneled into the start of continued growth or expansion, repays large amounts of debt voluntarily contracted just before its IPO in order to pay a dividend of $ 400 million. dollars to Sovos owners (in addition to paying off previous debt).

Although its products do sell and appear to be good quality food, they seem to have little to distinguish them from other food stocks. With its average product lineup and high leverage, Sovos may not be among the most appetizing dishes on the IPO table right now, and investors need to be careful.

This article represents the opinion of the author, who may disagree with the “official” recommendation position of a premium Motley Fool consulting service. We are heterogeneous! Challenging an investment thesis – even one of our own – helps us all to think critically about investing and make decisions that help us become smarter, happier, and richer.

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